Simple Moving Average

Most technical analysts use the Simple Moving Average, or the arithmetic mean.

A simple Moving Average adds up prices in its time frame and divides the sum by the width of the time frame. For example, for a 20-day simple MA of closing prices, add up closing prices for the past 20 days and divide the sum by 20. However, there are a few criticisms about the simple MA such that:

1)      Each price affects a simple MA twice—once when it comes in and another when it drops out.

2)      Only the days in the time frame that the average is based on are taken into account (for example, the last 20 days)

3)      It gives equal weight to each day’s price. The last day’s price receives the same weight as the first day’s price, which some analysts believe that there should be a heavier weight on the more recent data instead.

Exponential Moving Average

An Exponential Moving Average (EMA) helps overcome these criticisms. It assigns greater weight on the more recent data. It does not drop old prices from its time window, but rather, they slowly fade out after time.

Few people calculate indicators by hand these days since computers can do the calculations much faster and more accurately. But if you are interested in knowing how to do the calculation yourself, here it is:

EMA = P_today* K + Ema_yesterday * (1-K), where
- K = 2/(N+1)
- N = the number of days in the EMA (chosen by trader)
- P_today = today’s closing price
- EMA_yesterday = Yesterday’s EMA

How does Moving Average Work?

The most important part of a moving average is the direction of its slope.

-When the EMA rises and slopes up, trade the market from the long side.

-When the EMA falls and slopes down, trade the market from the short side.

-When an EMA starts constantly sloping up and down, it signals a trendless market and you are recommended to stop using trend-following methods until a new trend emerges.

EMA works in all timeframes but the best in weeklies, where it helps you stay better with the major trend. Therefore, many traders prefer trading in the direction of a weekly moving average.

Trading Techniques

When the prices move above MA, it is a buy signal.
When the prices move below MA, it is a sell signal.

When we buy near the moving average, we are maximizing our gains and minimizing our risks. The same rule applies to shorting in downtrends, where you are better off shorting near the EMA.

You can also use dual moving averages to identify trends and entry positions. For example, you can use the longer EMA to identify the trend, and the shorter EMA to find entry positions.  Moving averages in general help identify trends, decide whether it is better to trade long or short, and give us hints on when to enter a trade. To find exit points, we can use channels.

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.