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Moving Averages (EMA, SMA)
Moving averages smooth the price data to form a trend following indicator.
They do not predict price direction, but rather define the current direction
with a lag. Moving averages lag because they are based on past prices. Despite
this lag, moving averages help smooth price action and filter out the noise.
They also form the building blocks for many other technical indicators and overlays,
such as Bollinger Bands and MACD. The two most popular types of moving
averages are the Simple Moving Average (SMA) and the Exponential Moving Average
(EMA). These moving averages can be used to identify the direction of the trend
or define potential support and resistance levels.
SMA Calculation
A simple moving average is formed by computing the average price of a stock over
a specific number of intervals. Most moving averages are based on closing
prices. A 5-day simple moving average is the five day sum of closing prices
divided by five. As its name implies, a moving average is an average that moves.
Old data is dropped as new data comes available. This causes the average to
move along the time scale, or "across" a chart.
Examle
of a moving average. The above illustration shows an SMA (Simple Moving Average)
with a step period of 20. "Step" is the number of chart intervals
that the moving average is calculated.
EMA Calculation
Exponential moving averages reduce the lag by applying more weight to recent
prices. The weighting applied to the most recent price depends on the number
of periods in the moving average. There are three steps to calculating an exponential
moving average. First, calculate the simple moving average. An exponential moving
average (EMA) has to start somewhere so a simple moving average is used as the
previous period's EMA in the first calculation. Second, calculate the weighting
multiplier. Third, calculate the exponential moving average. The formula below
is for a 10-day EMA.
SMA: 10 period sum / 10
Multiplier: (2 / (Time periods + 1) ) = (2 / (10
+ 1) ) = 0.1818 (18.18%)
EMA: {Close - EMA(previous day)} x multiplier +
EMA(previous day).
A 10-period exponential moving average applies an 18.18% weighting to the
most recent price. A 10-period EMA can also be called an 18.18% EMA. A 20-period
EMA applies a 9.52% weighing to the most recent price (2/(20+1) = .0952). Notice
that the weighting for the shorter time period is more than the weighting for
the longer time period. In fact, the weighting drops by half every time the
moving average period doubles.
Lagging
The longer the moving average, the more the lag. A 10-day exponential moving
average will hug prices quite closely and turn shortly after prices turn. Short
moving averages are like speed boats - nimble and quick to change. In contrast,
a 100-day moving average contains lots of past data that slows it down. Longer
moving averages are like ocean tankers - lethargic and slow to change. It takes
a larger and longer price movement for a 100-day moving average to change course.
Simple Versus Exponential
Even though there are clear differences between simple moving averages and
exponential moving averages, one is not necessarily better than the other. Exponential
moving averages have less lag and are therefore more sensitive to recent prices
- and recent price changes. Exponential moving averages will turn before simple
moving averages. Simple moving averages, on the other hand, represent a true
average of prices for the entire time period. As such, simple moving averages
may be better suited to identify support or resistance levels.
Moving average preference depends on objectives, analytical style and time
horizon. Chartists should experiment with both types of moving averages as well
as different timeframes to find the best fit.
Example
of SMA vs. EMA. The white line shows a 20-period SMA, while the green line show
an EMA, also for a 20-period. Notice that the EMA "responds" more
quickly to price direction because it is "weighted" towards recent
data.
Lengths and Timeframes
The length of the moving average depends on the objectives. Short moving
averages (5-20 periods) are best suited for short-term trends and trading. Chartists
interested in medium-term trends would opt for longer moving averages that might
extend 20-60 periods. Long-term investors will prefer moving averages with 100
or more periods.
Some moving average lengths are more popular than others. The 200-day moving
average is perhaps the most popular. Because of its length, this is clearly
a long-term moving average. Next, the 50-day moving average is quite popular
for the medium-term trend. Many chartists use the 50-day and 200-day moving
averages together. Short-term, a 10-day moving average was quite popular in
the past because it was easy to calculate. One simply added the numbers and
moved the decimal point.
Trend Identification
The same signals can be generated using simple or exponential moving averages.
As noted above, the preference depends on each individual. These examples below
will use both simple and exponential moving averages. The term "moving
average" applies to both simple and exponential moving averages.
The direction of the moving average conveys important information about prices.
A rising moving average shows that prices are generally increasing. A falling
moving average indicates that prices, on average, are falling. A rising long-term
moving average reflects a long-term uptrend. A falling long-term moving average
reflects a long-term downtrend.
Double Crossovers
Two moving averages can be used together to generate crossover signals. In
Technical Analysis of the Financial Markets, John Murphy calls this the "double
crossover method". Double crossovers involve one relatively short moving
average and one relatively long moving average. As with all moving averages,
the general length of the moving average defines the timeframe for the system.
A system using a 5-day EMA and 35-day EMA would be deemed short-term. A system
using a 50-day SMA and 200-day SMA would be deemed medium-term, perhaps even
long-term.
A bullish crossover occurs when the shorter moving average crosses above
the longer moving average. This is also known as a golden cross. A bearish crossover
occurs when the shorter moving average crosses below the longer moving average.
This is known as a dead cross.
Moving average crossovers produce relatively late signals. After all, the
system employs two lagging indicators. The longer the moving average periods,
the greater the lag in the signals. These signals work great when a good trend
takes hold. However, a moving average crossover system will produce lots of
whipsaws in the absence of a strong trend.
Example
of a double crossover. The illustration above shows two EMA's. The green line
is a 20-period EMA, while the yellow line is for a 50-period EMA. Note the circled
area, which shows the 20 EMA crossing the 50, which indicates a bullish move.
There is also a triple crossover method that involves three moving averages.
Again, a signal is generated when the shortest moving average crosses the two
Price Crossovers
Moving averages can also be used to generate signals with simple price crossovers.
A bullish signal is generated when prices move above the moving average. A bearish
signal is generated when prices move below the moving average. Price crossovers
can be combined to trade within the bigger trend. The longer moving average
sets the tone for the bigger trend and the shorter moving average is used to
generate the signals. One would look for bullish price crosses only when prices
are already above the longer moving average. This would be trading in harmony
with the bigger trend. For example, if price is above the 200-day moving average,
chartists would only focus on signals when price moves above the 50-day moving
average. Obviously, a move below the 50-day moving average would precede such
a signal, but such bearish crosses would be ignored because the bigger trend
is up. A bearish cross would simply suggest a pullback within a bigger uptrend.
A cross back above the 50-day moving average would signal an upturn in prices
and continuation of the bigger uptrend.
Support and Resistance
Moving averages can also act as support in an uptrend and resistance in a
downtrend. A short-term uptrend might find support near the 20-day simple moving
average, which is also used in Bollinger Bands. A long-term uptrend might find
support near the 200-day simple moving average, which is the most popular long-term
moving average. If fact, the 200-day moving average may offer support or resistance
simply because it is so widely used. It is almost like a self-fulfilling prophecy.
Do not expect exact support and resistance levels from moving averages, especially
longer moving averages. Markets are driven by emotion, which makes them prone
to overshoots. Instead of exact levels, moving averages can be used to identify
support or resistance zones.
Conclusions
The advantages of using moving averages need to be weighed against the disadvantages.
Moving averages are trend following, or lagging, indicators that will always
be a step behind. This is not necessarily a bad thing though. After all, the
trend is your friend and it is best to trade in the direction of the trend.
Moving averages insure that a trader is in line with the current trend. Even
though the trend is your friend, securities spend a great deal of time in trading
ranges, which render moving averages ineffective. Once in a trend, moving averages
will keep you in, but also give late signals. Don't expect to sell at the top
and buy at the bottom using moving averages. As with most technical analysis
tools, moving averages should not be used on their own, but in conjunction with
other complementary tools. Chartists can use moving averages to define the overall
trend and then use RSI to define overbought or oversold levels.
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