Moving Averages- A Comprehensive Guide !!!

9/20/2017

Moving Averages- A Comprehensive Guide !!!

Techno-Funda Techno-F unda Society


Caution: Ladies & Gentlemen, this is your captain speaking. The journey is going to be long but I assure y ou, a good one indeed. ind eed. So, get yourself a big cup of coffee, settle-in comfortably and here we go. Everyone who is an enthusiast of Technical Analysis (TA) knows about "Moving Average". However, there are a lot of people who are just starting out and want to learn more about moving averages or those who know about them but not formally. Well, I've written this post for you. Moving averages are one of the most basic tools that a warrior of technical analysis must have in his arsenal. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Wait !!! I said, "most basic", but don't get get misled. They are one of the most powerful tools out there. Simple things must be mastered well if one wants to master the subject. Just think of it; addition, subtraction, division and multiplication are the most simple concepts in mathematics but they are the most powerful ones and everything is built upon them. Similarly, a lot of other tools in TA, like Bollinger Bands, MACD and several others, are built upon moving averages. So let's roll up the sleeves and get dirty !!! Before I talk about moving averages specifically, let us talk a bit about Indicators in general. In technical analysis, there are only three original orig inal primary data items namely 'Price' 'Price',, 'Volume' 'Volume' & & 'Open Interest (in case of Futures & Options)'.. Everything else is just a derivative of either one of them or a Options)' combination of them. To analyse the primary data (Price/Volume/Open Interest), there are several 'Indicators & Overlays', Overlays', which are calculated and plotted on the chart. An indicator or an overlay is a certain formula applied on the primary data items and is used to analyse the market from different viewpoints. The only difference between and indicator and an overlay is that an indicator is presented in a separate window (above or below price window) and an overlay is drawn on the price window itself itself along with price. Examples of indicators would be Moving Average Convergence Divergence (MACD), On Balance Volume (OBV) and so on. And, examples of overlays would be Moving Averages, Bollinger Bands and so on. All indicators & overlays can be divided into two types namely 'Leading' 'Leading' & & 'Lagging' 'Lagging'.. Leading indicators & overlays are those which lead the price action and are used to predict predict or forecast the prices in future. Lagging indicators and overlays are those which lag the price action and are used to confirm the existing price action.

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You must have also heard the term, 'Oscillators'. Oscillators are just a type of indicators whose value oscillate between 0 and 100. Some examples are Stochastics, Relative Strength Index (RSI) and so on

Coming back to moving averages !!

What Are They ? Ever seen those curvy and squiggly lines overlaying the price chart? They are moving averages. Moving averages are a type of lagging overlays (Now you know why I deviated from the main topic above). They are lagging in nature means they are used to confirm the price action and they are overlays, means they are drawn on the price window itself. As the name suggests, a moving average is an average which is moving. Confusing? Let's break it down. What's an average? An average is a central point of a set of numbers which is generally calculated by adding the numbers and dividing the sum by their total count. So, if you need to take an average weight of Rahul (70 Kg), Sunil (65 Kg), Ajay (68 Kg), Rohit (74 Kg) and Ram (80 Kg), this is how we'd do it. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Average weight= (70 + 65 + 68 + 74 + 80)/5 = 71.4 Kg

Alright, but what's MOVING about it? Remember, this is a stock market tutorial and not a math's class and stock prices are always moving. So, when we go out to take average of stock prices, they keep moving. A new price data keeps getting added to the calculation while an old price data keeps getting removed from the calculation. Confusing? no problem, I'll cover it later.

Why Do We Need It? Since stock prices are always moving, they appear to be random and meaningless and thus a system is needed which smooths out the noise and randomness from the price and presents a clean picture. Moving averages do just that thing. They smooth out the noise from the prices and confirm the price trend. There are several types of moving averages but only two of them are most usable, practical and popular. The two most common types of moving averages are, "Simple Moving Average (SMA)" and "Exponential Moving Average (EMA)".

Let's kill them one at a time !!!

Simple Moving Average (SMA) As the name suggests, they are quite simple. SMA is computed by calculating simple average of prices of a security (generally closing prices) over a period of time. Let's understand it with an example. Here, I have taken closing price data of 20 sessions (from 17th August 2017 http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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to 14th September 2017) of Ashok Leyland Limited and calculated 3-Period SMA, 5-Period SMA and 10-Period SMA.

Points to Note 1.) Let's take the example of 3-Day SMA calculated above. See how the average is moving. For the first 2 days, no SMA is calculated. The first value of a 3-Day SMA appears on the close of third day and same with 5-Day and 10-Day SMAs. 2.) To calculate first value of a 3-Day SMA, the average of Day 1, Day 2 and Day 3 is taken. Then, to calculate second value of 3-Day SMA, Day-1 is removed from the calculation and Day-4 is added. So, the second value of a 3-Day SMA constitute Day 2, Day-3 and Day-4. Similarly, to calculate the third value of 3-Day SMA, Day-3, Day-4 and Day-5 are taken. This is why it is called a moving average. With every next value, a past period disappears from the calculation and a future period gets added to the calculation. 3.) You can calculate SMA over any time period. In the example above, I have calculated 3,5 and 10-Period SMA. You can also take 20-Period, 50http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Period, 100-period SMA or of any other period that you may like.

4.) Another thing to note is that since the primary price data that I have taken is daily closing prices, so a 10-Period SMA means a 10-Day SMA and so on. You can use price data of any time-frame. So, for example, if you use weekly closing prices as primary data, then a 10-Period SMA will mean a 10 Week SMA. If you use closing prices of every 1 Hour to calculate the SMA then a 10-Period SMA will mean 10-Hour SMA. If you use closing prices of every 10 minutes to calculate the SMA then a 10-Period SMA will mean 10(10 Minute) SMA or a 100-Minute SMA. Interesting, isn't it? 5.) Also observe that the 3-Day SMA value and 5-Day SMA value are closer to the price than the 10-Day SMA is the farthest. This is because a 10-Day SMA value includes data of past 10 days hence it does not reflect the current price as closely as a 3-day or 5-Day SMA do. Time to see the real action now. Let's put on the chart (Chart-1) of Ashok Leyland Limited to see the whole thing clearly.

See how the 3-Day SMA is the most responsive to price change. 5-day SMA is also moderately responsive to price change and 10-Day SMA is the least responsive to price change. Due to this property of moving averages, while comparing two SMAs, the one with smaller period is called FAST SMA and the one with longer http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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.

,

-

-

Day SMA, former is Fast SMA and latter is Slow SMA. While comparing 5Day SMA and 10-Day SMA, former is Fast SMA and latter is Slow SMA.

All moving averages have an inherent lag in them as they are based upon past prices. I know you must be feeling like this right now.

But don't worry. Robin Sharma says, "All change is hard at first, messy in the middle but gorgeous in the end". So, let's move onto EMA now.

Exponential Moving Average (EMA) EMA reduces the lag a little bit but as I said, lag is inherent in all moving averages. But comparatively, EMA has lesser lag than SMA. Other than resolving lag issue a bit, EMA also solves another problem. See, while calculating SMA, all price points are given equal weight. What I mean is that if you calculate a 20-Day SMA, the price of the security 20 days before is given as much importance (weight) as today's price. This is not right practically. You'd agree that yesterday's price is definitely more important than price 50 days old price. I am sure you all remember the post on "Why Stock Prices Move"? If not, then you can read it by

clicking

here. And people tend to remember near term prices much more than old http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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. , . , does EMA solve this issue? EMA solves this issue by giving more weight to recent prices while calculating the average. Due to this, EMA calculation is a bit more complex than SMA .

But hey, good news !!! You don't really have to calculate either SMA or EMA manually. So, if you are not interested in getting into it, you can skip this calculation part and go straight to the next part of the post. As I said that you don't have to calculate these things as all the charting platforms create SMAs and EMAs at the click of a button. Of course that's wonderful. But there is a dark side to it as well. And that is that it makes you lazy. In earlier times, when there were no charting software, people used to calculate indicators manually and plot them manually on the paper. That gave them a feel of indicators and price action. So, I am not suggesting that you should get back to plotting indicators and overlays by hand but knowing the logic of calculation will surely help you in forming trading strategies. EMA is calculated in 3 steps: a.) Calculate the SMA (EMA calculation has to start somewhere) b.) Calculate the weight-multiplier. c.) Calculate EMA. -


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You know how to calculate the SMA. Step-2 So, let's come to second step of calculating weight-multiplier. Weight-multiplier = (2/ (Time Period + 1) ) So, if you want to calculate 3-Period EMA, the weight-multiplier will be: (2/ (3+1) ) = 0.5 or 50% weight For a 5-Period EMA, the weight-multiplier will be: (2/ (5+1) ) = 0.33 or 33% weight For a 10-Period EMA, the weight-multiplier will be: (2 / (10+1) ) = 0.1818 or 18.18% weight Please notice that as the period is increasing, the weight-multiplier is decreasing. In fact, if you'd double the period, the weight multiplier will get half. Step-3 EMA will be calculated as follows: (Close - EMA (Previous Day) )*Weight-multiplier + EMA (Previous Day)


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Points to Note All the 5 points which applied to SMA (1 to 5) are equally applicable to EMA as well. Let's see how EMAs show up on chart (Chart-2).

Congratulations, you've just finished the basic concept of both http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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SMA and EMA. You're progressing really well.

Now, having understood both SMA and EMA, there must be two questions that must be brewing in your mind, yes exactly two.

Question 1 Which EMA is better, SMA or EMA? Question 2 Which time-period is best to get good results?

Good News !!! There is only one answer to both the questions. Bad News !!! The answer is that there is no answer.


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This is just like asking, "which car is the best car?". You see, there is no answer to this question. It all depends upon your requirements. If your requirement is sheer speed, Ferrari will fit the bill. If your requirement is safety, Audi can be the car that you're looking for and if your requirement is luxury, Bentley might satisfy you. See, there is just no on answer. Similarly, there are several ways to approach the decision of choice between SMA & EMA and Fast moving average & Slow moving average.

SMA Vs EMA As you all observed above that the only difference between an SMA and EMA is that SMA gives equal weight to all the prices while EMA gives more weight to recent prices by applying a weight-multiple. So, it is evident that EMA will respond to price action more effectively that SMA. In other words, an EMA is slightly Faster than SMA. Remember I told above that a short period moving average is faster than a long period moving average. But, periods being equal, EMA is faster than SMA. Let's see it on chart(Chart-3).


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So, you can clearly observe that SMA has more Lag than EMA. So, which one to use? The answer is that you must experiment with both of them and see which one fits the price structure in a better way. Both have their own benefits and limitations. While SMA is true average of the prices and thus acts as better support and resistance but it gives late signals. EMA gives timely signals but it tends to give false signals as well due to more sensitivity. So, the only way to find the perfect one is to experiment.

Short Vs Long Moving Averages There is no formula here too. But yes, let me tell you few general practices. The most famous time periods are 10-Period, 20-Period, 50-Period, 100Period and 200-Period. Short term traders swear by 5 to 20-Period moving averages. Medium term trend-followers are most interest in 20 to 50-Period moving averages while long term traders or investors use 100 to 200-Period moving averages. Some traders use a 9-Period EMA while other use a 10Period SMA. It all depends upon their style of trading, time-frame and the suitability on that specific price chart.

Moving Average Strategies There are several trading strategies based on moving average but the most popular strategies can be classified into 2 categories, Price Crossover and http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Moving Average Crossover. Let's take them one on one, one by one (no pun). Price Crossover The most simplest moving average strategy is to buy when price crosses above the average and sell/short when price crosses below the moving average. When price moves above the moving average, it is called a bullish crossover and when price falls below the moving average, it is called a bearish crossover. Let's understand it from the point of view of a short-term swing trader. I'd simulate multiple situations using different Period EMAs and see how signals are generated. Let's assume that a buy signal is generated every time price crosses above the moving average and sell/short signal is generated every time price crosses below the moving average. Also, note that cross will be valid only if price closes above or below the moving average. Reliance Industries Limited is taken as an example. Case-1: 10-Period EMA (Chart-4)

As can be seen, though a 10-Period EMA generated signals quickly but it generated a lot of false signals as well which would be bad profit and loss statement as brokerage expense will be incurred but money won't be made.


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ase- :

- er o

ar -

One can infer a lot of things from this chart. One, that the number of whipsaws (false signals) drastically reduced and the length of valid signals also increased. In other words, a 20-Period EMA allowed us to stay with the trend longer than a 10-Period EMA. Case-3: 50-Period EMA (Chart-6)

You can see that it allowed us to stay in the trend a lot longer than both 10Period and 20-Period EMAs while shortening the whipsaws. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Case-4: 100-Period EMA (Chart-7)

Can you see how the number of buy/sell signals reduced from 10 in case of a 10-Period EMA to just 2 signals? You got the point, right? The more you'd increase the length of look-back period, the less the number of signals will be generated and less whipsaws will be there. But, then what's to think about it? Let's just use a 100-Period or better a 200-Period moving average and ride the trend. It's not that simple. See, while an investor or a cash-trader (those who take delivery of shares) will prosper using a 100-Period or 200-Period moving average, a futures trader will get bankrupt. The reason is that while a 100Period moving average won't even change its course on a 3-5% fluctuation in price, a trader's risk capacity might only be 0.5% to 1%. So, price will fall a lot before the long term moving average will generate a signal thus exposing the trader to the vagaries of the market. The other problem is that it will generate signals less often thus giving a trader less opportunity to make money. So, it's a fight between sensitivity and reliability . While a short period '


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,

period moving average will be reliable, it will take a lot of price movement for it to move thus creating very less opportunities for a trader. But, there is a Sub-Strategy of price crossover strategy called Double Price Crossover. In this, 2 moving averages are used, one short period and one long period and the strategy will be as follows. The long period moving average will be used for direction of the trade and the short period moving average will be used for the timing of the trade. So, if price is above long period moving average, only long trades taken. And a short trade will only be taken if price is below long period moving average. However the trade will be taken only when price moves above or below short period moving average. Let's understand it better with an example. Let's say we take a set of two averages, 20-Period EMA and 100-Period EMA. First will be our timing tool and second will be our direction tool. And this is how it will work:

Let's see it on chart Case scenario (Chart-8)


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Now, compare it with Case-2 (Chart-5). As you can see, in case-2, a total of 6 signals were generated. 3 signals were valid and 3 were whipsaws. In this case, a total of 7 signals were generated. 3 signals were valid, 3 were in no trade zone and only 1 was a whipsaw. See, this filtering mechanism of using 2 moving averages reduced the whipsaws from 3 to 1 and converted rest of the whipsaws as no trade zone.

Now, let's come to the next strategy. Moving Average Crossover In this strategy, moving average is not seen with relationship to price but with other moving average. So, 2 moving averages are taken, one short period and one long period. A long signal is generated when short period average crosses above the long period moving average and a sell/short signal is generated when short period average crosses below the long period average. When a short period moving average crosses above a long period average, it is called Golden Cross. And, when a short period moving average crosses below a long period average, it is called Death Cross. Any combination of short-long averages can be taken but the terms Golden Cross and Death Cross are used mostly in reference to 50-200 average combination. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Case Scenario (chart-9)

Since we are not concerned with price crossing above or below any moving average and only with moving averages crossing each other, only 2 signals were generated. One signal got whipsawed and the other allowed us to ride the trend. Notice that so many times price fell below 20-Period EMA, at times price even fell below 50-Period EMA but since 20-Period EMA did not cross 50-Period EMA, no action was warranted. Any, combination can be chosen depending upon time-frame of the trader and suitability on specific price chart. So, one must play around with multiple sets of moving averages to see which set suits the price structure best. Some traders use a triple moving average crossover strategy , wherein they only buy when the shortest period average crosses above both the middle period and the long period average and they sell/short only when the short period average crosses below both the middle and the long period moving average. A very popular combination for triple crossover, among medium term traders, is 10-20-50 Period average.

Slope & Distance This is a very important concept regardless of which strategy you use. In case of price crossover strategy, along with the crossover, also check the slope of the moving average and observer the distance between price and moving average. As the trend gains strength, the slope of the moving average will get steeper and the distance between the moving average and the rice will increase. And as the trend will start losin steam the slo e of http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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moving average will get flatter and the distance between the price and the average will converge. In case of moving average crossover strategy, along with crossover, also check the distance between moving averages and slope of all of them. As the trend gains strength, the slope of moving averages will get steeper and the distance between moving averages will increase. As the trend dies, the slope of averages turn flattish and distance between averages decrease. So, slope and distance must also be taken into consideration before taking any decision.

Why So Many Strategies? The only reason that traders experiment with so many strategies is that they want to keep whipsaws as minimum as possible and want to elongate the trend riding period to as maximum as possible.

Uses of Moving Averages 1. Signal Generation I guess, I have covered this whole topic in the strategy section that how moving averages generate buy/sell signals. 2. Support/Resistance Prices tend to find support and resistance in their moving averages. Again, different period moving averages act as support/resistance in different terms. Also remember, a support moving average once broken turns into a resistance and vice versa. A 20-Period EMA can act as a short term support/resistance while a 200Period moving average can act as a long term support/resistance. Let's see the phenomenon with a couple of charts.


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As you can see that in Chart-10, a 50-Period EMA is overlaid on daily chart. Observe, how beautifully price took support at 50-Period EMA on every retracement (correction). These supports could have given perfect opportunities to go long on several occasions. The point is that it's not about 50-Period EMA. It's about finding the perfect fit for a specific price action. Thus, I am repeatedly saying that play around and have fun with moving averages. After all, all you have to do is to click and not calculate. Let's see an example of how moving averages can act as a resistance.

This is a wonderful illustration of how multiple period EMAs can switch roles. It is a ver ood situation as different levels of resistances are clearl http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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. visible and it will help a trader to form his trading strategy accordingly. This further emphasizes the need of experimenting with different time period moving averages on the same chart.

Few Important Points Before I Close 1. As I said that moving averages are lagging overlays, thus they are prone to whipsaws. Since moving average is a trending indicator, it will give wonderful signals while price is trending but it will generate a lot of whipsaws while price is moving sideways. One can judge the trend of the price by the slant (slope) of moving average. While a short term trend would be reflected in the slant of of a 10-20 period average, a long term trend might reflect well in the slant of 100-200 period average. Remember, a small price fluctuation will change the course of a 20-Period EMA but it will take a lot of price fluctuation to move a 200-Period EMA. This must be always remembered. 2. One size does not fit all. So, play around with different period moving averages and different strategies for every stock. Some price actions fit well with a 20-Period moving average while some fit well with a 50-Period moving average. The key is to find the best fit. Also, note that all the examples in the post are given on daily chart. However, while playing with different period moving averages, a good trader also experiments with the time frame of the chart itself. So, while a 20-Period EMA might perfectly suit the daily chart, on weekly chart, some other period might fit well. It's all about spending time with charts and moving averages. 3. Since, moving averages are prone to whipsaws, that is why so many strategies are used by traders such as moving average crossover, double price crossover, triple moving average crossover and so on. The agenda is to find the best fit. With experience, you would be able to know what works where. 4. Another strategy to avoid whipsaws is to create a time and price filter. For example, while using a simple price crossover strategy, don't just go long when price crosses above a selected time period moving average. Rather, set a filter in terms of time or price. A time filter can be that a bullish price crossover will only be valid if price stays above the moving average for 2 days or 3 days. As price filter can be that a bullish price crossover will only be valid if price penetrates the moving average by at least 1% or 3%. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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5. Finally, as with any other tool of technical analysis, moving averages are subjective and are best used in combination with other tools for best results.

If you've made it till here, YOU ARE A PASSIONATE FELLOW & STAND A GOOD CHANCE TO SUCCEED IN THE GAME OF TRADING. Let me end the post with the quote of legendary trader, Marty Schwartz.

Hope you enjoyed the post.

Happy Learning !!! Nishant Arora Techno-Funda Society (TFS) YOU CAN JOIN TFS FACEBOOK GROUP HERE. http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Chirag Jani

Great Bhai....Very timely published....Good learning material for weekend.... Nishant Arora

Thank You !!!

REPLY

phani

Good article ...I enjoyed reading it. It was very clear with your examples. Nishant Arora

Thanks for your kind words. Glad that it helped you.

REPLY

Mahesh Spiritual

What an EXCELLENT article. Thanx lot , cause how many site you must have searched , and shared with us. Thanks once again. Nishant Arora

Thank You Sir. Though, I did not have to search any site, it was all in my mind due to my readings of years ago. I rst researched about moving averages around 10 years ago. That time, I had to read it through so many places and then connect everything together. Then, I thought that why not make it easy for beginners and that's why I came up with this post. So, just had to give it a shape and words. Glad that you liked it Sir.

REPLY

Unknown

Thankyou :) Nishant Arora

You are most welcome.

REPLY

Anonymous http://www.technofundasociety.com/2017/09/moving-averages-comprehensive-guide.html

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Great artice sir! Nishant Arora

Thanks a lot.

REPLY

Anonymous

Now I understood how to analyse the stocks with moving average and how it is helpful when to execute the trade, thank you sir.. Nishant Arora

You are most welcome !!!

REPLY

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