Moving Average and Bollinger Band
learn these indicators to help you select your stocks!
A moving average is a widely used indicator in technical analysis that helps smooth out the short term “noise” and get the long term price movement. Two basic moving averages are the simple moving average (SMA) and exponential moving average (EMA).
Simple Moving Average (SMA) is the arithmetic mean of a stock’s prices over a period of time. The formula is:
SMA = (P1 + P2 + P3 + … +Pn)/n
Let’s look at an example of a stock with the following closing prices over 5 days:
50, 48, 45, 52, 53. If we want to use the 5-day moving average to predict the stock price of the sixth day, the calculation is: (50 + 48 + 45 + 52 + 53)/5 = 49.6. And If we only want to use the 3-day moving average to predict the stock price of the sixth day, the calculation is: (45 + 52 + 53)/3 = 50.
While the calculation for Exponential Moving Average (EMA) is more complex, but the basic idea is that it.gives more weight to recent prices.
The time length you choose for a moving average, also known as “look back period,” plays an important role in your decisions too. While shorter moving averages are used for short-term trading, longer-term moving averages more more suitable for long-term investors. An moving average with a short look back period will have a more zigzag pattern, and react much quicker to price changes than an MA with a long look back period. One example is shown in the following graph. The orange line is a 5-day simple moving average, while the blue line is a 30-day simple moving average.
The most common applications of moving averages are to identify the trend direction. A rising moving average indicates that the security is in an upward trend, while a declining moving average indicates that it is in a downward trend. While moving averages are useful on their own, they are also basis for other technical indicators, such as the Bollinger Band.
Bollinger Bands were developed and copyrighted by famous technical trader John Bollinger. A Bollinger Band is usually defined by a set of lines plotted two standard deviations (positively and negatively) away from the simple moving average (SMA) of the stock’s price, and it can be adjusted to user preferences. One example of Bollinger Bands with the 20-day SMA is as follows.
One information we can get from Bollinger Bands is the volatility of a stock. When the bands widen, it indicates that the market becomes more volatile; and if the bands contracts, it indicates a less volatile period. Another thing we should look at is when the stock price breaks the bands. If the stock price breaks the upper band, it indicates that the stock is overbought now, and we expect the price to go between in two bands again in the future. And if the stock price breaks the lower band, it indicates that the stock is oversold now, and we expect the price to go between in two bands again in the future. Bollinger Bands on its own may not be enough to trigger a buying or selling signal, and we should definitely use it with other technical indicators to make investment decisions.
