Stock traders rely on a series of technical indicators to influence their investment decisions. Among these is the stock moving average (MA), a particularly valuable tool now that the stock market is experiencing inflation-related volatility.
Here’s what investors should know about moving average stock trading — and how to harness this data for more favorable trades.
What Is Moving Average in Stock Market Trading?
It’s not uncommon to see rapid price movements in stock trading, whether localized to a single stock or spread across an entire index or market.
A stock moving average is designed to provide the average price of a particular company over a designated period of time. A rising moving average indicates a general uptrend, while a declining moving average indicates that the stock’s price is falling.
By calculating the moving average, stock market traders can minimize the effects of market volatility. They can also compare moving averages to determine the relative value of stocks, or they can compare a stock’s moving average to historical data to evaluate its potential future performance.
Moving averages are thus an important factor in technical analysis, which is a field that relies on mathematical evaluations of price movements and stock market indexes to determine the change in momentum of a particular security.
Types of Moving Average in Stock Market
There are two types of moving averages in stock market trading, each with its own merits and limitations.
Simple Moving Average (SMA)
A simple moving average (SMA) is the most direct way to calculate the average price of an asset. To determine the SMA, you can simply calculate the arithmetic average price of a stock over a given period of time.
The formula for calculating the SMA is as follows:
SMA = (A1 + A2 + A3 + … + An) / (n)
Where “n” represents the number of time periods averaged.
For example, imagine you calculate the SMA for a two-week (10-day) period using the following closing prices:
- Week 1: 30, 32, 34, 35, 33 (average per day = 32.8)
- Week 2: 36, 38, 36, 39, 37 (average per day = 37.2)
Using the above formula, you get:
SMA = (32.8 + 37.2) / 2
SMA = 35
Thus, the average daily stock price is 35 for the two-week period in question.
Exponential Moving Average (EMA)
The exponential moving average (EMA) is a bit more complex, as it assigns more value to recent stock prices. In contrast, the SMA assigns equal weight to all closing prices across the period analyzed.
The formula for EMA is as follows:
EMAt = [(V x s) / (1 + d)] + EMAy x [1 – (s/(1+d))]
In this equation:
- EMAt = exponential moving average today
- EMAy = exponential moving average yesterday
- V = value today
- s = smoothing factor
- d = number of days
The smoothing factor “s” is always calculated as 2/(d+1). Thus, a 10-day period would have a smoothing factor of 2/11, or roughly 0.18.
Simple Moving Average vs. Exponential Moving Average
Is an exponential moving average better than a simple moving average? Sometimes it is, but not always. Generally, the time frame dictates how the potential effectiveness of each method.
On a longer timeline, an EMA may be more accurate since it gives recent data extra weight, but that’s not a hard and fast rule. Traders rely on both methods to gain a clear picture of how an asset is performing.
Moving Average: Stock Trading Applications
How is the moving average used in stock trading? Moving averages can be used in several ways to evaluate a stock’s past performance and make inferences about its future movement.
Identifying and Confirming Stock Trends
By analyzing the moving average, stock traders can identify trends within a stock’s price movement, or confirm the existence of trends they believe are happening. In other words, a moving average can smooth out the noise of volatile stock data to chart the direction in which a stock is moving.
Stock traders commonly use graphs to plot trendlines through the data. A graph will provide a clear visual representation of the stock’s direction. By calculating the moving average, stock traders have a clearer picture of the stock’s overall value.
Crossovers
Traders commonly look for stock crossovers, which occur when a stock price crosses above (or below) the moving average. This indicates a change in an established trend.
For instance, when a short-term moving average crosses above a long-term moving average, it’s known as a “golden cross.” This is a bullish pattern since the stock’s short-term average is breaking out of its historical, long-term averages. A golden cross generally indicates a bull market, and the signal may be reinforced by high trading volumes.
Moving Average Convergence/Divergence (MACD)
In a moving average convergence/divergence (MACD) strategy, traders look at the relationship between two moving averages. This involves subtracting a 26-day EMA from a 12-day EMA.
The MACD plots a signal line on a graph and can be used to identify or confirm trends. Traders also use the MACD to identify ways in which a stock is breaking out of its historical pattern, interpreting these instances as either buy or sell signals.
Bollinger Bands
Moving averages can be evaluated along with Bollinger Bands, which chart the price levels above and below a simple moving average of a stock price. According to John Bollinger, the creator of this method, if the Bollinger Bandwidth drops below 2%, it will lead to major changes in the S&P 500 market index.
These lines form something of an envelope and indicate whether prices are high or low, meaning the stock has been overbought or oversold.
Pros and Cons of Moving Averages in Stock Trading
Stock traders use moving averages alongside a handful of other technical indicators to evaluate the performance of a stock. That’s why it’s important to understand the pros and cons of moving averages in stock evaluations. Here are some things to consider about SMAs and EMAs.
Pros of Moving Averages in Stock
Moving averages allow traders to:
- Gain insight into general trends without the noise of volatile data
- Identify or confirm trends in a stock price
- Evaluate a stock’s historical data to plot a probable course for the future
- Look for crossovers and buy/sell signals for trading stock
- Integrate moving average data into other stock evaluation tools
Moving averages can be valuable for evaluating a stock’s historical performance, and they provide great clarity even when prices are volatile.
Limits of Moving Averages in Stock
It might be better to speak of the limits (rather than the cons) of moving averages in stock evaluation. Moving averages are limited because:
- Historical trends aren’t always good indicators of future performance
- The mathematical formulas used are intimidating to some novice traders and investors
- Averages may be lagging indicators that don’t reflect current trends
- Moving averages don’t always identify cyclical patterns
- Historical data may not be available for all companies
For example, startups might not be suited for evaluations based on moving averages. The reason is simple: These companies lack the robust historical data needed to draw meaningful conclusions about their price performance. But even long-term stocks can produce false signals, which is why investors must base their decisions on a holistic approach to stock research.
Gain the Best Insights
Moving average stock calculations are a great way to find clarity when stock prices are at their most volatile. While moving averages are limited to historical data, they can be extremely useful for traders who seek to identify or confirm pricing trends.
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