Before knowing how to use Moving Average in trading, you must understand basically what the average is. Averages are estimates calculated to find out how the subject has performed as a whole on which the data is obtained. The average helps us to reach the central value. We calculate the average of a particular dataset by adding all the information of the data together and dividing it by the total number of the dataset.
To understand how to use Moving Average in trading, you must also learn about some relevant concepts like the simple Moving Average in stock market, Moving Average crossover system, and Exponential Moving Average in stock market.
There is a great importance of using Moving Averages to identify spot market trends of stock/index. This means Moving Averages help to determine the direction of the trends and find out more about its resistance and support levels. Moving Average is also known popularly as MA, and it is a technical indicator that shows the stock's average value price for a specific period. It is helpful in identifying the underlying trends easily. With the change in the stock's price, there will be an increase or decrease in the value of the average. Let us understand how to use Moving Average in trading to make more profit.
Experts compare the relationship of Moving Averages with the underlying asset's price. The rising Moving Averages show that there is an increase in the price, and falling Moving Averages show that there is a decrease in the prices. To know the uptrend, the price is placed above the long-term Moving Average, and when the price is placed below long-term averages, you can know downtrends. When the price of securities rises above the Moving Average, the traders get buy signals. If the price of securities goes below the Moving Averages, the traders get sell signals.
Simple Moving Average in stock market
Simple Moving Average in the stock market is also known popularly by its short-form SMA. To calculate SMA, you need to have a dataset usually having a range of closing prices for different periods. Then you need to add the most recent prices. Then divide it by the number of times to get the average. The reaction by short-term Moving Averages to the price of the underlying assets is quicker, unlike the long-term Moving Average, which reacts or responds slowly.
Below is the formula to calculate the SMA,
Simple Moving Average = An / n
An = A1+A2+A3 … An.
n = time periods
Let us put the above formula into an example,
The total of closing price of the Indian Company is 1257.3.
The total number of closing prices is 5.
So, SMA = 1257.3 / 5 = 251.46
The date will be taken only for 5 days as the stock market is closed on Saturdays and Sundays. If you want to add one more day, the data will be forwarded one day. So if there are Saturdays and Sundays between the next 5 days from 15/03/2022, it will include the 15th, 16th, 17th: 18th, and 21st dates.
So the Simple Moving Average is just an average that shows the average price of a period. The trend direction can be known with the help of SMA. It helps to smooth the price data and technical indicators. If the Simple Moving Average considers a longer period, the result will be smoother.
Exponential Moving Average in stock market (EMA)
EMA or Exponential Moving Average in stock market is a Moving Average that applies more weight to the data point considered for calculation. EMA is also known as Exponentially Weighted Moving Average by experts.
EMA is similar to SMA but a little different as it is more reactive. The Exponential Moving Average is the sum of closing prices of a period and the number of observations.
When a trader uses a combination of two Moving Averages, it is called "smoothing" in the stock market. This technique is helpful to smooth out the data of closing prices by updating the average price constantly. With the help of this technique, the investors can remove fine-grained variation. So the Smoothed Moving Average here is also known as the Exponential Moving Average in stock market.
To calculate the EMA value, you need to keep adding the closing prices of the previous sessions. Then you need to divide the total number of days. Let us say that the total number of days is 10, and then you will need to calculate the 10 Day EMA. The 12 to 26 days of EMA are for the short term, while the EMA calculated for 50 to 200 days are for long-term Moving Averages. Traders find EMA useful in technical analysis and have more weight if used properly.
You can easily understand EMA using its formula,
EMA = Price(today) × k + EMA (yesterday)×(1−k)
K= 2 / N+1
In simple words, the calculation must include today's EMA, yesterday's EMA, the number of EMA days, and constant k.
EMA gives the information with more weightage than SMA to the closing prices while SMA shows the equal weight to all the average closing prices. But still, the use of Exponential Moving Average in stock market does not consider the most recent data. EMA needs to calculate the closing price of the stock of a period, the sum of the days to calculate the SMA, for example, 20 days. Then the total of all the closing prices will be divided by a total of 20 days.
Moving Average Crossover System
When a short-term Moving Average, which is a fast Moving Average, crosses a long term Moving Average which is a slow Moving Average, then a Moving Average crossover system takes place.
By using the crossover system, the investors can find out and predict the change in future trends. These trends help find out the signals for buying and selling any assets. An investor can develop different Moving Average strategies with the help of different available Moving Averages.
The Moving Average crossover system considers two or more Moving Averages, short and long-term Moving Averages, to indicate a signal.
Traders in the stock market consider different lengths to produce the signals on crossovers and divergence. These lengths include 10 day, 50 day, and 200-day Moving Averages.
The Moving Average helps spot the market trend and allows the investors to find better selling and buying opportunities in the market. When trading is above the average price, it is good that the investors are optimistic about the stock, and trading below average shows the pessimistic side of the investors.
If applied to charts, the crossover system helps the traders find out about upcoming trading opportunities. With the help of a crossover system, the traders can know about the signals that reflect the market strength. This can also benefit the new traders.
The other names of the Moving Average are rolling average or running average. Based on the investment strategies, the traders choose the method of averages. You can use the information while considering the moving averages.