A moving average is a technical indicator that market analysts and investors may use to determine the direction of a trend. It sums up the data points of a financial security over a specific time period and divides the total by the number of data points to arrive at an average. It is called a “moving” average because it is continually recalculated based on the latest price data.
Analysts use the moving average to examine support and resistance by evaluating the movements of an asset’s price. A moving average reflects the previous price action/movement of a security. Analysts or investors then use the information to determine the potential direction of the asset price. It is known as a lagging indicator because it trails the price action of the underlying asset to produce a signal or show the direction of a given trend.
KEY TAKEAWAYS
- A moving average (MA) is a stock indicator commonly used in technical analysis.
- The moving average helps to level the price data over a specified period by creating a constantly updated average price.
- A simple moving average (SMA) is a calculation that takes the arithmetic mean of a given set of prices over a specific number of days in the past.
- An exponential moving average (EMA) is a weighted average that gives greater importance to the price of a stock in more recent days, making it an indicator that is more responsive to new information.
How to Choose the Proper “Length” of a Moving Average
The “length” or the number of reporting periods including the moving average calculation affects how the moving average is displayed on a price chart.
The shorter its “length”, the fewer the data points that are included in the moving average calculation, which means the closer the moving average stays to the current price.
This reduces its usefulness and may offer less insight into the overall trend than the current price itself.
The longer its length, the more data points that are included in the moving average calculation, which means the less any single price can affect the overall average.
If there are too many data points, price fluctuations may become “too smooth” that you won’t be able to detect any kind of trend!
Either situation can make it difficult to recognize if price direction may change in the near future.
For this reason, it’s important to select the length (or periods) that provides the level of price detail appropriate for your trading timeframe.
In next section, we need to explain to you the two major types of moving averages:
1. Simple Moving Average
2. Exponential Moving Average (EMA)
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