Moving averages come in different types: simple SMA, exponential EMA, and their derivatives. All of them are lagging indicators and have one purpose - to determine the current trend of financial assets by smoothing out fluctuations and noise. By assessing the direction of a trend, traders can make those trends work in their favor and increase the number of profitable trades.
A moving average is the result of averaging the price of an asset over a selected period - N. Once calculated, the final value is displayed on the chart as a curved line so that traders can view smoothed data rather than focusing on daily price fluctuations. It is also possible to construct multiple moving averages by adjusting the number of time periods used in the calculation.
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The simplest form of the indicator, known as the simple moving average SMA, is calculated by finding the arithmetic average of a given set of values. For example, to calculate a simple 10-day moving average, the sum of the closing prices of the last 10 days is taken and then divided by 10. If a trader wants to construct a 50-day moving average, the same type of calculation will be performed, but it will include prices for last 50 days.
Recent data is considered to be more significant to the valuation of an asset than older data and should have a greater impact on the final result. Thus, to give more weight to the new data, an exponential moving average EMA was created.
Learning the formula for calculating it may not be necessary for many traders, as most programs automatically perform the calculations. However, it is still useful to know it for understanding:
Since more attention is paid to the latest data when calculating the EMA, it reacts faster to price changes, unlike the SMA. This sensitivity is the main reason why many traders choose to use EMAs rather than SMAs.
⚙️ Setting up moving averages
Moving averages are a fully customizable indicator, which means it can freely choose any time frame. The shorter the time interval, the more sensitive the moving average is to price changes, and vice versa. There is no correct time frame when setting up moving averages. The best way to figure out which one works best for you is to experiment with several different time periods until you find one that suits your strategy.
Some of the main functions of a moving average are to identify the direction of a trend, identifying potential areas where an asset will find support or resistance. Additionally, moving averages can be useful when setting stop loss orders.
📈 Trend
Trend detection is one of the key functions of moving averages. Moving averages are lagging indicators, meaning that they do not predict a trend reversal, but rather confirm an existing one. As you can see in the chart, a stock is in a rising trend when the price is above the moving average and the moving average itself is directed upward. And on the contrary, the price located below the downward moving average confirms the downward trend. To determine the trend, it is best to use moving averages MA200d or MA365d:
🛡️Support
Another common use of moving averages is to identify potential price supports. The price fall is often slowed down where the moving average passes. In addition, a rebound from key moving averages, such as those with periods of 50 or 200 days, is possible, but this requires confirmation of other technical indicators.
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