In finance, a moving average (MA) is a stock indicator commonly used in technical analysis. Moving averages are calculated to identify the trend direction of a stock or to determine its support and resistance levels. It is a trend-following or lagging, indicator because it is based on past prices.
By calculating the moving average, the impacts of random, short-term fluctuations on the price of a stock over a specified time frame are mitigated.
Simple moving averages (SMAs) use a simple arithmetic average of prices over some timespan, while exponential moving averages (EMAs) place greater weight on more recent prices than older ones over the time period.
Understanding a Moving Average (MA)
The longer the period for the moving average, the greater the lag. A 200-day moving average will have a much greater degree of lag than a 20-day MA because it contains prices for the past 200 days. 50-day and 200-day moving average figures are widely followed by investors and traders and are considered to be important trading signals.
Investors may choose different periods of varying lengths to calculate moving averages based on their trading objectives. Shorter moving averages are typically used for short-term trading, while longer-term moving averages are more suited for long-term investors.
While it is impossible to predict the future movement of a specific stock, using technical analysis and research can help make better predictions. A rising moving average indicates that the security is in an uptrend, while a declining moving average indicates that it is in a downtrend.
Similarly, upward momentum is confirmed with a bullish crossover, which occurs when a short-term moving average crosses above a longer-term moving average. Conversely, downward momentum is confirmed with a bearish crossover, which occurs when a short-term moving average crosses below a longer-term moving average.
Simple Moving Average
A simple moving average (SMA), is calculated by taking the arithmetic mean of a given set of values over a specified period. A set of numbers, or prices of stocks, are added together and then divided by the number of prices in the set.
Charting stock prices over 50 days using a simple moving average may look like this:
Exponential Moving Average (EMA)
The exponential moving average gives more weight to recent prices in an attempt to make them more responsive to new information. To calculate an EMA, the simple moving average (SMA) over a particular period is calculated first.
Then calculate the multiplier for weighting the EMA, known as the "smoothing factor," which typically follows the formula: [2/(selected time period + 1)].
For a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952. The smoothing factor is combined with the previous EMA to arrive at the current value. The EMA thus gives a higher weighting to recent prices, while the SMA assigns an equal weighting to all values.
Simple Moving Average (SMA) vs. Exponential Moving Average (EMA)
The calculation for EMA puts more emphasis on the recent data points. Because of this, EMA is considered a weighted average calculation.
In the figure below, the number of periods used in each average is 15, but the EMA responds more quickly to the changing prices than the SMA. The EMA has a higher value when the price is rising than the SMA and it falls faster than the SMA when the price is declining. This responsiveness to price changes is the main reason why some traders prefer to use the EMA over the SMA.
Source: Investopedia, Moving Average (MA): Purpose, Uses, Formula, and Examples, accessed 27 December 2023, <https://www.investopedia.com/terms/m/movingaverage.asp>