A moving average is a technical indicator that combines price points of an instrument over a specified time period. The most common form of moving average is a simple moving average, often referred to as SMA or MA. This is a lagging indicator, meaning it gives a view on past price performance, and is pretty straightforward to calculate.
The most common uses of moving averages are over 50-day, 100-day and 200-day time periods, referred to as 50MA, 100MA and 200MA. These provide investors with a short, medium and long-term view of how a price has performed over the relevant number of days.
The moving average is calculated by adding up the close prices at the end of each trading day over the preceding number of relevant trading days and then dividing that sum by the total number of days.
For example an investor wants to calculate an ultra-short moving average, say 5MA. The stock the investor is looking at closes at the following prices over the preceding 5 days:
- 11p on Day 1
- 12p on Day 2
- 13p on Day 3
- 14p on Day 4
- 15p on Day 5
By adding up the close prices for each day (11p, 12p, 13p, 14p & 15p) the total equals 65. Dividing 65 by 5 (the MA’s time period) totals 13p. Therefore the 5MA for the example stock being looked at is 13p.
How a moving average works
A moving average can provide investors with useful information on current price trends and also provide possible warnings of a change in trend. For example, if a stock trades above its 200MA it is widely accepted that the stock is in a bull market.
The chances are it will continue to rise. If a stock is trading below its 200MA then it might be in a bear market and the chances are it will continue to trade lower. When stock prices reach a long-standing moving average, this can often be a critical point for determining what might happen next.
In a bull market, if a price drops to a long-standing moving average and rallies positively off it then this is often a bullish indicator. Equally, if a price drops to a long-standing moving average and keeps dropping then this is often a bearish indicator, which might suggest a change in trend to a bear market.
The same logic applies in reverse in a bear market. If a price rises to a long-standing moving average, reverses and drops again then this is often a bearish indicator. However, if a price rises to a long-standing moving average and keeps on rising then this could be a bullish indicator, suggesting a change in trend to a bull market.
Types of a moving average
There are four types of moving average:
- Simple moving average (SMA)
- Exponential moving average (EMA)
- Smoothed moving average (SMMA)
- Linear weighted moving average (LWMA)
The two main types are a simple moving average and an exponential moving average. The example we gave above is of a simple moving average, calculating the exponential moving average involves a more complex calculation and gives more weight to recent prices. Both have their place and neither is better than the other.
Other types of a moving average include smoothed moving average and linear weighted moving average. These two types of moving average require complicated calculations, a linear weighted moving average heavily weights recent price data, giving the most recent price more importance and each prior price less importance. This type of moving average can help traders react to price changes quickly and can help clearly define any price trends.
A smoothed moving average is the same as an exponential moving average but with a longer time period applied. With a smoothed moving average, historic and recent prices are given the same level of importance or weight and take all available data sets into account, meaning it is not limited to a fixed period.
Advantages of a moving average
There are many advantages of using a moving average, including:
Insights into stock trends
Calculating a simple moving average provides traders with a good indication of whether the stock is in a bull or bear market and can inform their decisions on whether to buy or sell stock. Using a longer time period to calculate the moving average can help traders gain more insight into stock trends.
Signals start and end of trends
A moving average can help traders recognise a change of direction. If the stock has been on a downward trend and begins to rise it is a strong signal that the trend may be coming to an end and may be a good time to invest.
Determine good entry points
Traders with an interest in a stock they’re not currently trading can use a moving average to find a nice entry point. When a stock rises above the calculated moving average, this can be used as a signal to buy.
Disadvantages of a moving average
The disadvantages of using a moving average include:
Draws trends from historical data only
While using data from past price information has its uses, it does not take into account changes in fundamental factors such as new competitors, an increase or decrease in product demand or changes to the structure of the company.
Using only one time period can be inaccurate
The most common uses of moving averages are over 50-day, 100-day and 200-day time periods, although shorter periods can be used such as 5 or 10 days. Relying on just one specified time period to calculate the moving average can lead to inaccuracies. What may look like an uptrend in a 50-day moving average could be part of a countermove in a downtrend in a 200-day moving average.
Don’t work well in non-trending or sideways markets
Moving averages can be an invaluable tool in trending markets, but for sideways and non-trending markets the usefulness and accuracy of moving averages can be limited. The signals created in these markets, if acted upon, could be costly to investors.