Moving Average

Moving Average is a trend indicator which is widely used in technical analysis, due to its simplicity and effectiveness. It is also known as trend following or lagging indicator as it is based on past prices. There are two most commonly used moving averages:

• Simple Moving Averages (SMA)
• Exponential Moving Averages (EMA).

Simple Moving Average is a simple average of the prices of a security over a defined time period. This average can be calculated for any time frame i.e. from minutes, hours, days, months or even years. It is usually calculated on the closing prices, but some traders may also calculate SMA based on other parameters such as high, low and open prices.

Let’s take the closing prices of HUL for 5 days:

SMA for HUL   = 8095.85 / 5 = 1619.17

Hence, in this case the average closing price of HUL over last 5 trading sessions is Rs. 1619.17

Once we receive the data for the next trading date 16/09/2018, we will discard the data of 07/09/2018 to calculate the 5 day moving average again. This process helps us to keep updated with the latest average of the stock price and thus the name ‘moving average’.

Exponential Moving Average is pretty much similar to the Simple Moving Average, however all the data used in the calculation of SMA is given equal importance like the price on 11/09/2018 is given equal importance as the price on 14/09/2018. EMA, on the other hand, gives more importance to recent prices on the premise that price reflected on an earlier date has discounted all the known and unknown information and thus making the new prices more sacred.

Lets take the similar prices of HUL for calculation of EMA.

EMA for HUL   = 24285.20 / 15 = 1619.01

Hence, in this case the exponential moving average price of HUL is 1619.01. As we continue to receive new data for next dates, the older dates will be discarded to update the EMA.

Comparison of SMA vs EMA: One may notice that EMA is more reactive to prices compared to the SMA, as it gives more importance to the current market prices and is thus more preferred by the traders.

Application of SMA and EMA can be done while identifying buying and selling opportunities. When the prices are trading higher than its average price, it indicates that the traders are willing to buy the stock at a price higher than its average price and are optimistic of the price to rise. This gives the traders a buy call. Similarly when the prices are trading below the average price, it means that the traders are pessimistic and are willing to sell the stock at a lower than average price. This gives a sell call.

Moving Average Crossover system

These averages work very well in scenarios where the share prices are trending in any of the directions. However, in cases of sideways movements these average prices may not be great indicators as they may give too many trading signals. Thus, one needs to apply them carefully in order to gain from these indicators.

As there is a problem with plain vanilla moving average system generating too many trading signals, traders resort to use moving average crossover system. It gives the trader fewer trades even in a sideways market.

The moving average crossover system combines two moving averages and is also known as ‘smoothing’. An example would be to combine a 50 day moving average and a 200 day moving average. In this case the shorter moving average can also be termed as the faster moving average and the longer day moving average can be termed as slower moving average.

In the crossover system, traders buy or go long when the short term moving average goes above the long term moving average and usually stays in the trade till the condition is satisfied.

Applying the rule vice versa, traders sell their positions or go short when the short term moving average is less than long term moving average.

What is important to note is that moving average is a trend following system and will work efficiently as long as there is a trend.