Welcome back!
We have now been introduced to the types of technical indicators that traders use as an essential tool in predicting market movement. Let us move forward by explaining the various types of indicators starting with the Moving Average.
Moving Averages are price-based, lagging (or reactive) indicators that display the average price of a security over a set period of time. A Moving Average is usually used to gauge momentum as well as to confirm trends, and define areas of support and resistance. Basically, Moving Averages smooth out the “noise” when trying to interpret charts. Noise is made up of fluctuations in both price and volume. Because a Moving Average is a lagging indicator and reacts to events that have already happened, it is not used as a predictive indicator but as an interpretive one for confirmations and analysis. A predictive indicator is a ratio, index, report, or other measurements that signals a company or market’s direction in advance.
Moving Averages form the basis of several other well-known technical analysis tools such as Bollinger Bands and the MACD.
There are a few different types of Moving Averages but the most common ones among traders are
- The Simple Moving Average (SMA): a technical indicator that can aid in determining if an asset price will continue or if it will reverse a bull or bear trend. It calculates the average of a range of prices by the number of periods within that range. Short-term averages respond quickly to changes in the price of the underlying security, while long-term averages are slower to react.
- The Exponential Moving Average (EMA): also referred to as the exponentially weighted moving average, is a type of moving average (MA) that places a greater weight and significance on the most recent data points. It reacts more significantly to recent price changes than a simple moving average simple moving average (SMA), which applies an equal weight to all observations in the period.
Moving Averages takes a set of data (closing prices over a specified time period) and outputs their average price. Unlike an oscillator, Moving Averages are not restricted to a number within a band or a set range of numbers. The MA moves right along with price.
The timeframes or periods used can vary quite significantly depending on the type of technical analysis being done. One fact that must always be remembered, however, is that the longer the timeframe being used, the more lag there will be. Likewise, the shorter the timeframe, the less lag there will be. This means that Moving averages with shorter timeframes tend to stay close to prices and will move right after prices move. Longer timeframes have much more cumbersome data and their moves lag behind the market’s move much more significantly.
Determining what time frames should be used, is up to the trader’s discretion. Essentially, any period under 20 days would be considered short-term, anything between 20 and 60 would be medium-term, and those longer than 60 days would be regarded as long-term.
From the chart, it can be seen that the EMA responds to price changes quicker than the SMA.
Let us stop here for now, we will explain the various ways traders use the MA in trading in our next post.