4.1 Overview of Moving Averages
A moving average is just that – an average. Only, if it’s moving, it means it is being calculated for a certain period of past, at every point of time. Thus a 10-day moving average on Day 1 will be calculated by adding up the prices of the last 10 days and dividing by 10. On Day 2 it will again be calculated by adding the 10 latest prices. Thus the calculation is repeated by dropping one day and adding the latest day’s price.
Please note that generally the closing price of each period is used for calculating the average. This is important if you are trading in some other markets instead of Forex and are using daily charts because unlike Forex, in stock markets the day’s open is generally different from the previous day’s closing price.
There are various types of moving averages and we shall be talking about those in the next lessons but the objective would basically be the same – identify the underlying trend by averaging out, or smoothing, the period-to-period fluctuations in price. A period will be an hour on hourly chart or a day on a daily chart and so on.
Normally the moving average is plotted along with the price on a chart, and an indication of the future trend is obtained by viewing slope. We can also use moving averages of multiple time periods on the same chart and their crossovers are used to indicate change in the trend situation as well as entry and exit signals.
Moving averages are used for the following:
- Identifying trends and trend reversals.
- Gauging the strength of the trend.
- Identifying possible resistance and support levels.
- Entry and exit signals for trade positions.
The choice of period for calculation of the moving average has a bearing on its ‘smoothness’ – the longer the period, the smoother the graph. But the trade-off here is that longer periods make the moving average ‘slower’ in giving signals on a change in trend.
The two most popular moving averages are the Simple Moving Average and the Exponential Moving Average though weighted moving average is also used as a technical indicator.
We know you’re itching to learn how to rake in the green stuff using averages. Patience, move on to the following pages and we’ll tell you all!
- Moving Averages - An Introduction