Moving Averages: Meaning, Working and Types

Stock markets are an inquisitive place to undertake business activities. They offer lucrative returns and the risk tolerance level associated with them is on the higher side. However, it is not easy to deal with complexities of the share market because there’s an underlying volatility affecting it. 

In order to make the trading experience simpler and more efficient, there are various technical indicators that allow market participants to accurately gauge trends prevailing in security and take up appropriate positions. Moving averages are one such technical tool that you can use to gauge the direction of a trend. 

Let’s discuss this concept in greater detail!

What are ‘Moving Averages’?

Moving average is a type of technical indicator used in stock markets to determine trends prevailing in a security. In simple words, we can say that moving averages give us an idea of whether there are bullish or bearish sentiments in a security at a given point in time. 

It is a moving or constantly changing variable. You can compute a simple moving average by summing up the price points of a security over a period of time and dividing this summation by the number of days under consideration. However, it is not a static indicator, as you need to keep on computing this data by taking into consideration the most recent price data set. 

Also called a lagging indicator, it always trails the price actions of the concerned underlying asset and signals the underlying directional movement in the same. Now that you are well aware of the meaning of moving averages, it is time to shift to other intriguing aspects of the same. 

What are the features of a Moving Average?

• During a phase of a sideways market trend, this technical indicator may give you trading signals like buy or sell signals. These signals can at best lead to only marginal profits. 
• A trader may generate sustainable profits only when one or two of these signals lead to an incredibly huge rally resulting in significant gains. 
• One drawback of it is that you will not be able to differentiate the biggest winner from a series of recurring small trades.
• One important thing that you should consider while using moving averages is that you must consider all trades as they come up and avoid being selective and judgemental about signals received from the same. 

What are the types of Moving Averages?

There are two types of moving averages which are as follows: 

• Simple Moving Average

It is a common type of moving average. You can compute simple moving averages by just calculating the mean of a number of datasets. First, you need to sum up the price point datasets for a specific period of time. After that, you shall divide this summation by the number of days under consideration. 

The result of this calculation will come up as a simple moving average. The most common examples of simple moving averages are 8 day, 15 day, 20 day, 50 day, 100 day and 200 day simple moving averages. 

• Exponential Moving Average 

Another form of moving average is the exponential moving average. It is a weighted way of determining moving averages. In this type of moving average, the most recent dataset is given a higher weightage over a past data point. For example, yesterday’s price of a security will be given a higher weightage than last week’s price. 

For calculating exponential moving average, you will have to first find out the simple moving average of the respective security’s price points. After computing this value, it undergoes a formula in which a decreasing weightage is assigned to every passing day. 

Because of the weightage component, we can say that an exponential moving average is quite reliable and useful as it helps to assess the fluctuating price movements better than simple moving averages. 

Simple Moving Average or Exponential Moving Average: Which is better? 

Now that you have understood the meaning of simple and exponential moving averages, let’s see which of these two averages is apt for traders in different scenarios. 

Both these technical indicators help in gauging the directional trend of a security’s price. However, they differ in the emphasis that they give on changes occurring in security’s price. 

As seen above, an exponential moving average tends to showcase a higher sensitivity towards recent price changes. Therefore, we can say that exponential moving averages are quite sensitive to respond to recent price movements. 

However, the method of calculating an exponential moving average is quite complicated as it assigns different weightage to price sets. 

On the other hand, a simple moving average is quite easy to calculate. It is a simple means of different price points over a period of time. 

As seen from this discussion, we can say that both have their benefits and limitations. The most ideal moving average may vary from trader to trader depending on their objectives and market knowledge. 

Final Word 

Moving averages are quite an effective technical indicator that help traders to gauge trends prevailing in security. It is of immense benefit when one is undertaking day trading or position trading. However, if you are looking to use this technical indicator, it is imperative that you consider trading signals from other instruments as well. This is because over relying on any one parameter may induce false signals and subsequently inaccurate trade.

Frequently Asked Questions 

Q1. How can you use moving averages?

Ans. You can use a moving average to get an idea about the trend prevailing in a stock. You can plot the calculated moving average. After this, you need to plot the market price of that stock. If the market price of that stock is higher than the computed moving average, it means that there is an uptrend in that particular stock. It can be used as support and resistance level.

Uptrend is a buying signal and you should try to purchase the stock as quickly as possible. 

Q2. What is the moving average convergence divergence (MACD) indicator?

Ans. It is a type of momentum oscillator indicator which also helps in ascertaining trends. Even though you will not be able to distinctly identify oversold and overbought securities by looking at this indicator, the crossover lines in this give out certain trading signals. 

Q3. What are the advantages of moving averages?

Ans. Moving average trading indicators are quite useful as they are quite easy to understand and compute when compared to other technical parameters. Moreover, it is very easy to spot a trend by looking at moving averages and doing subsequent forecasting. 

Q4. What is the difference between 200 and 50 day moving averages?Ans. The function and procedure of calculation are the same for both moving averages. However, a 200 day moving average is useful for identifying long term trends and a 50 day moving average is useful for recognising mid-term trends.