Calculating the Simple Moving Average
The Simple Moving Average (SMA) calculates the average of the last n prices, where Px represents the price at a certain period, and n represents the number of periods. The average moves because you do not use all the data, but only the recent periods:
For example, the moving average for four periods with prices of 1.2640, 1.2641, 1.2642, and 1.2641 gives a moving average of 1.2641 using the calculation (1.2640 + 1.2641 + 1.2642 + 1.2641) / 4 = 1.2641.
While knowing how to calculate the simple average is a good skill to have, trading platforms and charting tools calculate it for you. You define the SMA indicator from the chart indicators list and apply it to the chart. You then adjust the number of periods you want to use.
Adjustments to indicators are usually made in the settings menu section of the trading platform.
Calculating the Exponential Moving Average
The Exponential Moving Average (EMA) is a weighted average of the most recent prices. It uses a weight that decreases exponentially from each price/previous period. In other words, the formula gives more weight to recent prices than to past prices.
For example, the EMA for four periods has prices of 1.5554, 1.5555, 1.5558, and 1.5560. The last value gives the latest EMA value, which is 1.5558.
The EMA adjusts more quickly to price changes than the SMA. For example, when the price reverses its trend, the EMA will reflect the trend faster than the SMA, because the EMA formula gives greater weight to recent prices and less weight to prices from the past.
Calculating the Weighted Moving Average
The Weighted Moving Average (WMA) gives you a weighted average of recent prices, with the weight decreasing for each previous price. This works similarly to the EMA, but the WMA is calculated differently.
WMAs can have different weights depending on the number of periods used in the calculation. If you want to obtain a weighted moving average for four different prices, the most recent weight might be 4 out of 10. The previous period might weigh 3 out of 10. The third period can have a weight of 2 out of 10.
A weight of 4 out of 10, for example, means that you have 10 recent periods and their prices. You choose four of the most recent prices. This represents 40% of the WMA value. The price four periods back only represents 10% of the WMA value.
Uses and Interpretation of Moving Averages in Trading
Moving averages can be used for analysis and trading signals. For analysis, all moving averages help highlight trends. When the price is above its moving average, it means that the price is trading at a higher level than the average over the analyzed period. This helps confirm an uptrend. When the price is below its moving average, it means that the price is trading at a lower level than the average over the analyzed period. This helps confirm a downtrend.
When the price crosses above its moving average, it becomes stronger compared to what it was in the past, as the current price is now higher than the average. If the price crosses below its moving average, it becomes weaker compared to what it was in the past.
A long-term moving average and a short-term one can be added to the chart at the same time – for example, 20 and 50 periods. When the 20-period moving average crosses above the 50-line, it indicates that the short-term price momentum is trending upward. When the 20-period moving average crosses below the 50-line, it indicates that the short-term price momentum is trending downward.
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Also, combining moving averages with other indicators to provide trading signals. The EMA can provide buy signals when combined with Keltner Channels, which is an indicator that includes a high price, an average price, and a low price, creating a “channel” on the chart. The strategy may include buying near the EMA when the trend is upward and the price pulls back from the top of the Keltner Channel.
One type of moving average is not better than another; they calculate the average in different ways. Depending on the strategy you use, one type of moving average may work better than another. Experiment with different moving average combinations and see which one provides you with the best results.
You may find that for each market, you need to adjust your settings slightly. A 50-period SMA may provide excellent signals on one stock, for example, but not on another. A 20-period EMA may help isolate the trend on one futures contract but not on another. All moving averages are just tools, and their interpretation depends on the trader, as there is no indicator that works well all the time or in all market conditions.
Frequently Asked Questions (FAQs)
How can you add the moving average to the chart?
Moving averages are a technical indicator, so look for the button that allows you to add indicators. This may be in the settings menu, or it may be a dedicated button. From there, you can choose simple, exponential, and weighted moving averages. Once you add the moving average to the chart, you can adjust the number of periods, whether it uses the close or the low of the day, and other factors as such.
How should moving averages be formatted for day trading?
Day traders often use a mix of short-term and medium-term moving averages. For example, a trader might use an 8-day moving average, a 24-day moving average, and a 50-day moving average. Other traders may use a 6-month moving average or more, along with a short-term moving average.
Source: https://www.thebalancemoney.com/simple-exponential-and-weighted-moving-averages-1031196
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