The Moving Average Indicator

To an untrained eye, the market might look like an abstract concept that we’ve created to make trades and earn profits. But the market is best appreciated if thought of as a multi-cellular organism that manifests itself in the form of trends, which describe the market’s mood in a particular time frame. Therefore it is absolutely crucial to study and comprehend market trends to be capable of making predictions about how the market will behave in the near or distant future.

The Simple Moving Average Indicator (SMA)

One way to figure out these trends is by zooming out and looking at them as a collective, in other words averaging them over a specific time-line, a few days for example. We add up the prices of each day in a specific time-line and average them over those days. But as time progresses, new days arrive with their own price values, so if we wish to keep the time-line at fixed length we must throw away the old days’ prices and replace them with the prices of the most recent days. This way, the average keeps changing or moving with time, hence the Simple Moving Average becomes an indicator which captures the market behavior over a fixed-length period of time. If the Simple Moving Average (SMA) of a specific security goes up, the price (or the momentum) of that security might have a tendency to surge. On the other hand, a downward trend in the moving average might mean a tendency for decline in the prices or momentum of said security.

Take a period of five days for example, in which the closing prices of a hypothetical security are $31.5 $31.7 $31.6 $32.1 $32.3. Then the SMA of this period is

When tomorrow arrives and ends in a new closing price, we throw away the first $31.5 value and replace it with the new closing price value and so on.

The simple moving average is not thoroughly sufficient for predicting market movements. There are other more advanced moving averages that take additional parameters into account. We go over the most important and popular of them: The Exponential Moving Average (EMA)

The Exponential Moving Average (EMA)

One major problem with the SMA is that every price value is treated the same, while it is evident that the market is more substantially affected by the newest price values than by the older ones. The idea behind the Exponential Moving Average or EMA is that there should be a weight factor associated with every price value that determines how substantial it is compared to the other price values, hence sometimes called the Exponential Weighted Moving Average.

Where N is the newest price value, P is the previous period’s EMA (for the first time calculation we use an SMA instead), and K which is called the exponential smoothing factor or the multiplier is to associate the correct weight to the newest price value and it’s calculated like this:

Where n is the number of data points in a specific time period, so for a 5 day period n=5.

Market strategizing based on MA

Indicators such as the MA are usually used to confirm our already stablished notion by the price action. If the EMA is above the price trend of a security, it might be a signal of a downward trend and what’s called a bearish market. If the EMA is above the price trend then it could be interpreted as signal to an upward trend and what’s called a bullish market. If the EMA line is penetrating through the market then it means the market is moving sideways.

Trend reversals and Crossovers

When the price crosses above or below a moving average or vice versa, this might be an indication of a reversing in the market trend. A golden cross is when the MA of a shorter time period crosses above the MA of a longer time period, which might indicate an upward shift in trend’s trajectory, and a death cross is when the shorter-term MA crosses below the longer-term MA which might indicate a downward shift in trend’s trajectory.

Summary

The Moving Average indicator is a simple oscillator-type indicator which helps investors in predicting market’s behavior and potential trend reversals. It’s an average of market’s price values over a specific timeline, and the old price values are constantly replaced with newer ones, hence the name “Moving Average”. Just like every other indicator, the MA should not be applied on its own and must be accompanied with the already established notion about the market from price action.