Dolomite Learning Series: Moving Averages
What is a Moving Average?
A Moving Average is a lagging (based on past price action) indicator used in technical analysis to identify trends and evaluate general trends. Moving Averages are shown as a line that smooths the fluctuations in price action.
Figure 1 — Moving Average Example (SMA) — Source: Commodity.com
As you can see in Figure 1, a break above or below a moving average signals a change of momentum. Buying occurs during a convincing upward break of a long established Moving Average. Selling occurs during a convincing downward break of a long established Moving Average. The most commonly used moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average (SMA)
The Simple Moving Average is the simple average price of an asset over a certain number of periods. Short term SMA is more responsive to short term price volatility than long term SMA. The SMA gives equal weight to each day in the period.
Figure 2 — SMA Formula — Source: Investopedia.com
There are various timeframes for SMA. For example, a 20 day SMA takes an average of the closing price for the first 20 days and tomorrow the oldest price will be dropped from the average and tomorrow’s price will be added to the average. Some of the most popular lengths are 5, 10, 20, 50, 100, and 200. Traders will typically chose the length that best matches their trading tempo.
Figure 3 — SMA as a Momentum Indicator — Source: Fidelity.com
Exponential Moving Average (EMA)
The EMA gives extra weight to the more recent days in the average. This results in a more accurate and up-to-date average compared to SMA. The EMA formula is as follows:
Figure 4 — EMA Formula — Source: Investopedia.com
The three basic steps to finding EMA are:
- Find SMA.
- Calculate the multiplier for smoothing/weighting factor for the previous EMA.
- Calculate the current EMA.
Similar to SMA, the EMA is used in conjunction with price movement to assess momentum and identify trading opportunities. The lengths of EMA varies but is generally used within the same range I previously listed for SMA.
Figure 5 — Exponential Moving Average (EMA) — Source: Commodity.com
Thank you for reading this installment of the Dolomite Learning Series. I will be discussing common chart patterns to look for and what they indicate in the next installment. Happy Trading!
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Disclaimer: The information here is intended to be used for educational purposes only and is not financial advice. I am not a financial adviser.
