Successful stock trading requires an analytical mind. One must understand what drives the prices in any particular direction. The most common tool used by professional traders is the moving average.
What are stock market moving averages?
These are simple technical analysis tools that show the average price set for a specific period of time. A moving average helps a trader to define a trend, identify the changes in trend and forecast the future stock prices. It can be tailored to different time frames to suit both long-term and short-term traders. A moving average helps to cut down the amount of noise on trading charts. In addition, it can be used to identify resistance and support areas. If you want a smooth moving average that defines the price action, you should go for the longer time frame. Let me walk you through the most popular stock market moving averages;
Simple moving average - SMA
This is one of the simplest MA in technical stock analysis. It’s calculated by computing the average price of a stock over a specific number of periods. For example, to calculate a 14-day MA, you should add all the prices for the last 14 days, and then divide by 14. Understanding how simple moving average works can help a stock trader create and adjust the trading strategy. Since moving averages are lagging indicators when the prices are rising, the SMA will be below that line. However, moving average can sometimes give mixed signals when prices are not trending. In most cases, the SMA works well when the stock prices are trending. The longer the periods on SMA, the longer it will take long to react to price movements. Through SMA you can tell whether stock prices are ranging, trending up or trending down.
Exponential moving average - EMA
It reduces the price lag by adding more weight on the current stock prices. It’s the most preferred moving average in stock trading.EMA reacts on price change which is then deleted when new price value appears. This means that stock traders should give more emphasis on the current price action compared to the old one.
Calculating Exponential Moving Averages
First, one must calculate the SMA and the weighting multiplier. The current exponential moving average = (Current Price – Previous EMA) x Multiplier) + Previous EMA. The formula makes a lot of sense, since it concentrates on what the traders are doing currently.
Choosing the best moving average for stock trading
The choice of a moving average will depend on the time horizon and your analytical style. Long-term investors prefer to use MA with short time frames. For short-term trading, you should use SMA of 15 to 20 periods. On the other hand, the most important moving average to have on any stock chart is the 200MA. The stocks usually reverse many times in this area.
I’m sure you now have an idea what are stock market moving averages. Always remember, moving averages can give mixed signals and will always follow a particular trend. It’s recommended that you experiment the SMA and EMA on different time frames to see the one that best fits your price action strategy.