Technical indicators are used by traders to understand momentum in stock price movements.
There are dozens of different indicators. Different traders favor specific indicators depending on their strategy.
One of the most common and widely used technical indicators is the moving average.
It’s crucial to understand there are several types of moving averages. Each looks a little different on a chart and has varying significance when it comes to trading setups.
I know traders who love technical indicators and pay attention to several. Others choose only a few. If you join my Trading Challenge you’ll learn what I use (and why). You’ll also discover what other Challenge students are using in their trades.
Understanding moving averages is essential. There are several trade setups where a buy or sell signal is triggered, supported, or confirmed by this great technical indicator. The moving average is also the basis for several other technical indicators.
Let’s get started …
Table of Contents
- 1 What Is Moving Average (MA)?
- 2 Types of Moving Average (MA)
- 3 How to Calculate Moving Average and Use It While Trading
- 3.1 Moving Average Common Formulas
- 3.2 Support and Resistance Analysis
- 3.3 Moving Average Chart Setups
- 3.4 How to Use Different Time Frames to Analyze Moving Average
- 4 The Bottom Line
What Is Moving Average (MA)?
If you’re new to trading, looking at a chart can be a little overwhelming. But there are tools you can use to make sense of what you see …
If you look at a chart for a stock with high volatility (the kind I love to trade) you see big price swings and jumps. The chart looks ‘jagged.’ The moving average smoothes price movements into a curved line.
Because it is based on past price points — or data points — it’s considered a lagging indicator. The longer the period, the more the moving average lags. For example, a 200-day moving average lags more than a 50-day moving average.
So what is a moving average?
In its simplest form, a moving average takes the closing prices of a stock for a certain period (usually calculated in days) and averages the price. The average price is plotted as a line on the chart.
Common periods for moving average are 10-day, 20-day, 50-day, and 200-day. However, with modern charting software, you can set the number of days as well as intraday periods for calculation.
For example, I know a swing trader who uses a 9-day moving average based on the daily close. He compares it to another technical indicator — the volume weighted average price (VWAP) — to determine if a trade meets his criteria.
Traders are usually more concerned with short-term moving averages — say 10-day or 20-day — because there’s less lag. However, crossover of a short-term moving average in relation to a longer-term moving average is a common trading signal. More on that later in this post.
Types of Moving Average (MA)
There are different types of moving average. The three most common are:
- Simple moving average (SMA)
- Exponential moving average (EMA)
- Weighted moving average (WMA)
I’ll give a brief explanation of all three, then we’ll focus on the two most used by traders: the SMA and the EMA.
Simple Moving Average (SMA)
The simple moving average is the most common type of moving average. It takes a sum of past closing prices over a given period and then divides by the number of price or data points. A 10-day SMA takes the last 10 closing prices, adds them together, and then divides by 10.
Exponential Moving Average (EMA)
An exponential moving average gives more weight to the most recent data points or prices. This is done by adding a weighted multiplier to the equation. It is slightly more complicated but keeps the moving average line closer to the price changes you see on a chart.
A good way to think of it is this: The EMA reacts to price changes quicker than the SMA.
The Difference Between the EMA and SMA
The primary difference between EMA and SMA is the EMA has less lag time. On a chart, the EMA plot line adjusts faster in relation to recent price fluctuations. This is because of the weighted multiplier.
Weighted Moving Average (WMA)
Like the exponential moving average, the weighted moving average assigns more weight to recent data points. However, in a weighted moving average, distribution of weighting is equal. In an exponential moving average, the weighting is exponential.
Rolling average is another name for a moving average; it’s sometimes referred to as a rolling average in statistics.
Trailing average is another name for moving average. Moving average, rolling average, and trailing average mean the same thing — but different industries prefer one term over the other. Some MS Excel experts prefer the term trailing average.
How to Calculate Moving Average and Use It While Trading
With all modern charting and trading software, you can pull up technical indicators as overlays on the chart. In a moment I’ll show you how to do it, but first I want to show you how to calculate it yourself.
Even if you never do it this way again, it helps to understand what’s happening when you input data in the charting software. Yes, stock market analysis is largely automated now, but that doesn’t mean you should ignore how it works.
Moving Average Common Formulas
Ready to give it a go? Here’s how you calculate simple and exponential moving averages …
Simple Moving Average Formula
Take the closing prices for the number of days you want (known as the period), add them together, and divide by the number of days.
For example, a 10-day SMA adds the last 10 closing prices and then divides them by 10. It looks like this: [(Day 1 + Day 2 + … Day 9 + Day 10)/10] = SMA.
Let’s do it with real numbers. We’ll do a 10-day moving average. To keep it simple, we’ll use whole numbers for the closing stock price. Here’s the sequence of closing prices: 9, 7, 4, 6, 7, 8, 10, 11, 9, 11.
Now add them together, then divide by 10:
[(9 + 7 + 4 + 6 + 7 + 8 + 10 + 11 + 9 + 11)/10] = 82/10 = 8.20. Voilà, the simple moving average is 8.20.
Once the next closing price is known, drop the first number from the sequence and make the new closing price the last number.
Let’s say the next closing price is 10. In the equation, the first data point is now 7. We dropped the data/price point from 11 days ago and added the latest price. Now the sequence adds up to 83. Divide by 10 and you get 8.30. On and on it goes. Each new SMA gets plotted on the chart.
Exponential Moving Average Formula
The exponential moving average is a bit more complicated. You got this, right?
Here’s what the equation looks like: [Current day close – previous EMA] * [2/(n+1)] + previous EMA.
Before you do the calculation, let me explain a couple of things. Current day close is the last number in your set. Let’s take the second set: current day close is 10.
Previous EMA — we don’t know yet. In real-world EMA calculations, the more data points, the more accurate the output. But we have to start somewhere so I’m going to use the 10-day SMA from the example above. So we’ll go with 8.20 (previous day SMA).
Then in the equation is the period or number of days. In this case, 10.
Again, we’ll use SMA to calculate the first one. Remember your order of operations from math class?
Here it is: (10 – 8.2) * (2/11) + 8.20 = 1.8 * .18 + 8.2 = 8.52. ⇐ this is your EMA.
Notice the EMA is a little closer to the closing price than the SMA. In our example above, the SMA for this day (closing price 10) was 8.30. The EMA is 8.52. Each day you’d do the same thing. Input yesterday’s close and previous EMA, then balance the equation.
… And so on, and so forth…
Check it out…
Any modern charting software or tool lets you calculate moving averages, both simple and exponential . You put in the time period and — boom — plot line appears on the chart. You gotta love it. You can give it a try for free if you head over to Yahoo Finance or BigCharts.com
You can even have multiple moving averages on the chart and choose which color represents each period. Then you can use it for trading instead of spending hours with a calculator or a spreadsheet.
Support and Resistance Analysis
To make it simple, this is a chart of the DJIA (Dow Jones Industrial Average) for a one-year period. The DJIA is a stock index, which tracks a group of stocks together. There are several different indices but those most often mentioned on channels like CNBC are the DJIA, the Nasdaq, and the S&P 500.
Notice the gold line — that’s the 200-day SMA. The lavender line is the 50-day SMA. The pale blue ellipses represent moving average support. The pale green ellipses represent moving average resistance.
The reality is, traders and market makers play a psychological game of cat and mouse. One of the things they might look for is stock prices — or index prices as in the chart above — to move toward these lines.
Depending on their strategy, they may make a play or wait to see if the stock or index breaks the ‘barrier’ of the line.
Study the chart above again. Look at the gold line — the 200-day moving average — and notice how the price dropped below the line in the first two blue circles on the left. But there was enough support that the index bounced back off the line.
If the price moves past the line then traders are interested in whether that movement will hold. If you look closely, you’ll notice the 200-day moving average acted as both support and resistance over several days of trading. Look for the fourth blue ellipse from the left. Then the index once again rose above the 200-day SMA.
Before I go into a couple of chart setups I find useful, I want to warn you about one thing regarding moving averages and charts …
When you open your charting software (and pull up that stock you put on your watchlist last night) the scale of the chart often determines the scale of the data points.
(You are keeping a watchlist, right? No? Why not try my weekly watchlist to get started? Once a week I’ll send you a list of stocks to watch. It’s a great way to begin this process … and it doesn’t cost a cent.)
In other words, if you’re using a 100 ‘data point’ moving average but the scale is set to 5-minute candles, it’s not a 100-day average — it’s a 100 five-minute-data-point average.
Just be sure you’re seeing what you think you’re seeing. Be aware of the data you’re analyzing so you don’t draw false conclusions. Advanced charting and trading software, like StocksToTrade, lets you set the plot for the number of days you want AND the time frame for the candles.
Moving Average Chart Setups
Crosses – The Reversal
When a faster moving average crosses over a slower one, it’s often a major trading signal. For example, if the 9-day EMA crosses the 20-day EMA, it could be a sign of momentum that fits your trading strategy. It can signal a significant change in the recent trend.
If you look at the chart below, the white ellipse shows where the 9-day EMA crosses the 20-day EMA in a strong fashion. Some traders would use this as a signal to buy into the breakout.
Bounces – The Continuation
A bounce is the opposite of cross in trading terms. The faster moving average ‘bounces’ off the slower moving average.
For example, if the 50-day moving average bounces off the 200-day moving average it might signal a continuing trend. The stock price might drop to the level of support (the slower moving average) and bounce.
In the two charts below you’ll see examples of both crosses and bounces. It’s important to note that you will see both crosses and bounces on many charts — especially when you’re looking at penny stocks. Price action can happen very fast.
The first chart, CGC shows a clear cross of the 9-day EMA over the 20-day EMA. Then, nearly two months later you see a bounce which lasts a few days. Then, finally, another cross moving the opposite direction signaling a downward trend.
CGC shart showing 9-day EMA crossing 20-day EMA, then bounce, then another cross. Source: FreeStockCharts.com
The last chart I have for you today is similar. But in this case, the trend from the bounce continues for a longer period of time before the 9-day EMA crosses below the 20-day EMA.
ACB chart showing 9-day EMA crossing 20-day EMA, bounce, and crossing to the downside. Source: FreeStockCharts.com
How to Use Different Time Frames to Analyze Moving Average
By now you’ve discovered that moving averages can be set to different lengths of time or different speeds.
In the charts, you can clearly see the faster moving averages (fewer data points) follow the stock price more closely. You can also see that EMA is faster to ‘react’ than SMA because of the effect of the weighting multiple.
Here are a couple of things to consider when using moving average to analyze a chart. I’ll use the 200-day and 50-day moving averages for simplicity.
Key Characteristics From 200-Day Moving Average Chart
The 200-day moving average is often considered a strong gauge of support for a stock’s price. If a stock trends below the 200-day moving average then the trend is clearly down. The 200-day MA is the most common long-term technical analysis indicator.
Key Characteristics From 50-Day Moving Average
The 50-day MA is considered a mid-term indicator. Depending on your strategy, it can give you a much better idea of the recent trend.
The Bottom Line
Traders and market makers hold certain beliefs around common indicators and signals. Moving averages are one of the most common.
The more you understand how market sentiment reacts to prices approaching or crossing a moving average, the better.
There are even entire strategies based on moving averages. It’s a very important part of your education to understand this, even if you don’t trade using moving averages as signals.
Are you a trader? Do you use moving averages as a signal in your trading? Let me know how in the comments below. I want to hear from you!