Moving Average (MA) is one of the most popular and easy-to-use tools available for technical analysts. There are two main types of moving averages: simple moving average and exponential moving average.
How Do We Calculate Simple Moving Average?
A simple moving average is calculated by computing the average closing price of a security over a specified number of periods. For example, a 10-day moving average is calculated by adding the closing price for the last 10 days and dividing the result by 10. 1+2+3+4+5+6+7+8+9+10=55, 55/10 = 5.5 (Assuming that the closing prices for the 10 days are 1-10 consecutively). When you plot the moving average for each date on a graph, it forms a curve.
Trading Signals:
- A buy signal is triggered when closing prices cross above the moving average (MA).
- A sell signal is triggered when closing prices cross below the moving average (MA).
Example:
Let’s look at the stock charts for MSFT and YGE as an example. A buy signal is generated when prices cross above the 10 day moving average as circled in 1, 2, 3. A sell signal is generated when price crosses below the 10 day moving average.
Disadvantage:
The main disadvantage of a simple moving average is that it does not reflect the current trend quickly. For example, if the stock prices in the last 10 days for a certain stock were 100, 99, 98, 45, 44, 45, 43, 42, 43, 42, the simple moving average would be 60.1. This moving average is 50% above the current price which wouldn’t be accurate to trigger an entry signal. In other words, if there is an extreme high or extreme low in the stock price, it distorts the true value of the stock. For this reason, another type of moving average called exponential moving average (EMA) was developed, giving more weight to the most recent prices.
