Moving Averages – Everything you should know

The moving averages indicator is one of simplest yet widely used indicator across every markets including Forex, Futures and equities. It is one of the most popular indicator with many technical analysis relying heavily on the moving average. As the name indicates, the moving average indicator is nothing but a line that plots the average of price across the chart continuously. The average can be applied to Open/High/Low/Close or even to typical price, which is High/Low/Close or Median Price, which is High/Low and Weighted Close, which is High/Low/Close/Close.

Moving Averages are used to not only gauge the trend of the underlying security, they also act as dynamic support and resistance levels. Therefore it is not uncommon to see prices stall near a moving average.

The moving average relies on the number of periods it is calculating. Therefore a 10 Period moving average on a daily chart (average price of the last 10 days, or 10 daily candles) is plotted differently when the same 10 Period moving average is applied to a weekly chart (the average price of the last 10 weekly candles).

Types of Moving Averages

There are four types of moving averages that differ slightly from each other. Based on the type of moving average that is selected, the MA line is also plotted differently. Therefore it is essential to understand the types of moving averages in order to find the most ideal type of moving average to use.

Simple moving average

The Simple moving average is the most simplest. The average prices (ex: close) are calculated based on the period that is specified. So if a 10 SMA is applied to the Daily chart’s closing price, then the moving average calculates the average closing price of the past 10 days. In the SMA type of moving average, all the closing prices are given equal weight.

Some of the most commonly used SMA settings are 50 day simple moving average, 200 day simple moving average. Of course, traders can choose their own custom settings as well.

Exponential moving average

The Exponential moving average differs from the simple moving average, in that more weight is given to the latest data rather than equal weighting for all prices. The reasoning behind using an Exponential moving average or an EMA is that while past prices are important, the most recent price is the most important element. The EMA, due to its calculation therefore tends to react more to prices than the SMA, which tends to lag. The most commontly used EMA settings are 12, 26 day EMA. Some technicians also make use of a 200 day EMA.

Linear Weighted moving average

The Linear Weighted moving average or LWMA for short tends to give a higher weighting to recent price data. Unlike the EMA, the LWMA gives specific weighting to the prices. So a 3 day LWMA would multiply the most recent price data by 3, the previous price data by 2 and the last price data by 1. The LWMA therefore puts greater emphasis on the recent price data.

Smoothed moving average

The Smoothed moving average works almost similar to the Simple MA, but the data is smoothed by a factor of ‘N’ (the number of periods).

The daily chart below illustrates how each of the above four types of moving averages behave for the same price data.

Moving Averages - Technical Indicator
Moving Averages – Technical Indicator

From the chart, we notice the following:

Smoothed MA – Lags and reacts very slowly to price but tends to be smooth across the price. Notice that the Smoothed MA gaves a very late signal.
LWMA – Because the weights are assigned on order of importance, the LWMA is the first one to react to a change in trend.
SMA – The Simple moving average falls in between the LWMA and the EMA. But has a relative lag in regards to reaction to the prices
EMA – The EMA appears to be more stable than the others.

Other types of moving averages

Besides the above four moving averages, in recent times many technicians have developed modified versions of the above moving averages. To name a few:

  • TRIX
  • Jurik Moving Average

Importance of Moving Averages

Moving averages, since its inception has found its place among most technicians. It is considered to be a good indicator regarding depicting trends in the market. When prices continue to close above the moving average, an uptrend is indicated. Of course, higher the period, the more valid the trend strength is. So for example, if prices are above the 200-day SMA the market is considered to be in an uptrend. Therefore, Moving averages are almost always used in a trend following trading system. Moving averages however have their own disadvantages. In that, they are considered lagging indicators. This means that the market would have already made a significant move by the time the moving average indicates a change in direction. However, when used in conjunction with other oscillators, the moving average becomes a powerful indicator, giving traders the underlying trend.