Moving Average (MA) Indicator

moving average

What is Moving Average?

The Moving Average is one of the most versatile but underutilized of all technical indicators. The moving average is essentially a trend following indicator. It is an average of a certain body of data. For example, if a 20 day average of closing prices is desired, the closing prices for the last 20 days are added up and the total is divided by 20. The term moving is used because only the latest 20 day’s prices are used in the calculation. Therefore, the body of data to be averaged (the last 20 closing prices) moves forward with each new trading day. Kindly refer to the chart below:

Moving average MA indicator 1

There are a few types of moving average namely:

a) Simple Moving Average The simple moving average is the type used by most technical analysts. But there are some who question its usefulness on two points. The first criticism is that only the period covered by the average is taken into account. Second, the simple moving average gives equal weight to each day’s price. In a 10 day average, the last day receives the same weight as the first day in the calculation. Each day’s price is assigned a 10% weighting. In a 5 day average, each day would have an equal 20% weighting.

b) Linearly Moving Average In an attempt to correct the weighting problem, some analysts employ a linearly weighted moving average. In this calculation, the closing price of the 10th day (in the case of a 10-day average) would be multiplied by 10, the ninth day by nine, the eighth day by eight, and so on. The greater weight is therefore given to the more recent closings. The total is then divided by the sum of the multipliers (55 in the case of the 10-day average: 10+9+8+ ….+1). However, the linearly weighted average still does not address the problem of including only the price action covered by the length of the average itself.

c) Exponentially Smoothed Moving Average This type of average addresses both of the problems associated with the simple moving average. First, the exponentially smoothed average assigns a greater weight to the more recent data. Therefore, it is a weighted moving average. But while it assigns lesser importance to past price data, it does include in its calculation all of the data in the life of the instrument. In addition, the user is able to adjust the weighting to give greater or lesser weight to the most recent day’s price.

This is done by assigning a percentage value to the last day’s price, which is added to a percentage of the previous day’s value. The sum of both percentage values adds up to 100. For example, the last day’s price could be assigned a value of 10% (.10), which is added to the previous day’s value of 90% (.90). That gives the last day 10% of the total weighting. That would be the equivalent of a 20-day average. By giving the last day’s price a smaller value of 5% (.05), lesser weight is given to the last day’s data and the average is less sensitive. That would be the equivalent of a 40-day moving average.

Moving average MA indicator 2

40-day exponential moving average (Red Line) is more sensitive than the simple arithmetic 40-day moving average (Blue Line)

The use of Moving Average

a) How to use Single Moving Average
When closing price moves above the moving average (e.g. 20-day moving average), a buy signal is generated. A sell signal is given when prices move below the moving average.

Moving average MA indicator 3

b) How to use Two Moving Average

This method is called double crossover. Buy signal is generated when shorter MA crosses above the longer timeframe moving average. For example, MA 5 crosses above MA20. Sell signal is generated when shorter MA crosses below the longer timeframe moving average. (see figure below)

This method is called double crossover. Buy signal is generated when shorter MA crosses above the longer timeframe moving average. For example, MA 5 crosses above MA20. Sell signal is generated when shorter MA crosses below the longer timeframe moving average. (see figure below)

Moving average MA indicator 4

c) How to use Three Moving Average to Generate Signals
The most widely used triple crossover system is 4-9-18-day moving average combination, especially in futures trading. In an uptrend, the proper alignment would be for the 4-day average to be above 9 day which is above the 18-day average. In a downtrend, the order is reversed and the alignment is exactly the opposite. This is the 4 day would be the lowest, followed by the 9 days and then the 18-day average.

Moving average MA indicator 5

 

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