A moving average (MA) is a calculation used in statistics to analyze data points. A moving average is created by calculating a series of averages for different subsets of the overall data set.
A moving average in the stock market is an indicator used in technical analysis (a technique to understand and gain from the patterns of movement of the price of stocks and indices). Calculation of the moving average helps in smoothing out price data using a continuously updated average price. A moving average helps mitigate the effect of random and short-term variations of stock prices in a given time.
Types of moving averages
A simple moving average (SMA) is computed by working out the mean of the stock prices for a definite number of past days (the lookback period) – e.g. the past 10, 20, or 100 days.
Exponential moving averages (EMA) is an average that is suitably weighted by assigning greater weightage to recent stock prices. The EMA is therefore a more responsive indicator. The greater responsiveness of the EMA to changes in the price of the stock is the reason many traders tend to prefer the EMA stock to the SMA stock.
A 20-day MA is of value to a short-term trader as this follows the price more closely compared to a 100-day moving average, which would be of greater interest to a longer-term trader.
How to use moving averages when buying stocks?
Technical analysts use moving averages to determine if there is a change in momentum in the movement of a stock’s price. The moving average helps establish ongoing change. For example, if the price of a particular stock rises above its 100-day moving average, it may be considered a bullish signal.
Moving averages help in identifying the trend direction of a stock’s price and determining the support level and resistance level. These levels are used to indicate whether the stock prices will rise or fall below a certain level. They are indicative of the limit of the stock market’s range of movement.
Moving averages follow the price trend. It is considered a lagging indicator because it is calculated using past data on prices. The longer the duration of the look-back period for calculating the MA, the greater the lag. Therefore, a 200-day MA will have a greater lag than a 20-day MA.
The support level is the level below which the price does not fall and the price bounces up from the support level. The resistance level is the level beyond which the price does not rise and is the level at which the price is pushed down.
Trading strategies to consider before buying stocks
Crossover is a key moving average strategy. In a price crossover, if the price rises above or falls below a moving average, it signals a possible change in trend.
In another strategy, two moving averages are applied to a chart e.g., one 10-day and one 200-day. If the 10-day MA rises above the 200-day MA, it indicates an upward trend. This is taken as a buy signal: a golden cross.
However, if the 10-day MA falls below the 200-day MA, it signals a downward trend. This is taken as a sell signal: a dead/death cross.
