A moving average is a technical analysis indicator that blends specific price points of a financial instrument over a set period of time. The number of data points then gets divided, to give you a single moving line. It is one of the more popular technical indicators because it helps traders determine the direction of the present trend while minimizing the effect of noise or volatility.
There are various ways to use moving averages to determine a market trend. Moving averages identify the trend and provide dynamic support/resistance levels. They are based on historical data and lag the price while not being predictive. In general, shorter-term moving averages are more sensitive than longer-term moving averages.
- Simple moving average (SMA) adds up closing values and divides these by the number of observations
- When a new value is included, the first value drops off
- Weighted moving average (WMA) gives more recent values a higher weighting
- Exponential moving average (EMA) uses SMA and applies a multiplier for weighting
Key takeaways:
- The financial markets must be in a trend for moving averages to provide value
- Short term moving averages provide earlier signals but are often false signals, known as ‘whipsaws’
- There are three types of moving averages that should be understood: simple, weighted, and exponential