Have you ever wondered how to determine if the market is bullish, bearish, or even sideways? How do experts determine the long-term trend or trade based on trends?
The stock prices are constantly moving up and down during the trading session and this makes it difficult to understand if the market is going up or down. So we need something to smoothen out the minor fluctuations and give us a larger trend.
If we look at the above chart, it is difficult to determine where the price is heading, this is because of the ups and downs in the daily prices.
Now if we look at the same timeframe with a Simple Moving Average of 9 period lines plotted across the chart, it is relatively easier to determine the trend.
How to calculate the Moving Average?
We are all aware of the average from our basic maths class, it is the sum of all numbers, divided by the count of numbers.
Above is a simple average of 6 numbers, we add all the numbers and divide it by 6, giving us an average value of 4.5
The above is a diagram representing the average of 3 numbers in a series of 6 numbers with a moving window. The first average is an average of the first 3 numbers, then we slide the window and consider 2nd, 3rd and 4th numbers to determine the average. This way we would get 4 averages, and since we have a moving window of 3, this kind of average is called the Moving Average of 3 periods.
Why do we need a moving average?
As we saw determining trends is difficult when the prices are fluctuating, a moving average would get the average price of n period to “smoothen” the fluctuations. We can vary the period based on what kind of trend we want to see. For example, a 200-day SMA or a Simple moving average of 200 days, is usually regarded by most traders as the long-term trend, while a 13-day SMA or a Simple Moving Average of 13 days, is usually considered a short-term trend.
Based on your trading style, you would look for different trends, a long-term investor would generally care about long-term trends like 200-day SMA and ignore short-term trends, while a swing trader would look for reversals on short-term trends like 13-day SMA.
What is EMA (Exponential Moving Average)?
A simple Moving average places equal weight for each of the numbers, this could be an issue when you are looking at longer-term trends, as you do not care so much about very old prices, you care more about the current prices.
To solve this very issue, an Exponential Moving average was created, which places higher importance on recent prices.
EMA is calculated by the following formula.
EMA = Price (today) * k + EMA (Yesterday) * (1 -k)
k = 2 / ( n + 1) where n is the number of periods
If we see the EMA value are a factor of the current price and the last EMA value. The first EMA value is a simple average of first 3 numbers, the second EMA is a function of the current number and the first EMA.
Conclusion
SMA and EMA are both very useful tools in the hands of a trader to determine the overall outlook of the market. There are other indicators like Moving average crossover, usually called Golden Crossover or Death crossover based on whether they are trending up or down, and MACD which is based on moving averages.
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