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What are moving averages, and how to read them

November 10, 2023
Last Update December 07, 2023
#analysis
#TA

A moving average is a technical indicator that helps traders and investors to determine the support and resistance levels and the price movements in the future.

A moving average is calculated by summing up the data points of an asset and then dividing the result by the number of these data points; that’s why it is called an average. The data is recalculated constantly, which is why the average is moving.

The most popular moving averages are the following.

Simple Moving Average (SMA)

This is the simplest indicator. It is obtained by adding recent data points and then dividing the result by the number of time periods. It is a lagging indicator because it is obtained from past data. It can be calculated for different price types: high, low, close, and open.

This indicator is used to determine the support and resistance levels, and buy and sell points.

For example, if closing prices were: 23, 23.40, 23.20, 24, and 25.50, we will calculate the SMA as follows:

SMA = (23 + 23.40 + 23.20 + 24 + 25.50)/5 = 23.82.

Exponential Moving Average (EMA)

EMA is based on the most recent price points when compared to SMA. For example, to calculate EMA for the last 20 days, you first need to calculate SMA for the same period (you can check how to do it in the previous paragraph). After SMA is calculated, calculate the multiplier for smoothing (weighing) EMA. Usually, the following formula is used to do so.

2 ÷ (number of observations + 1 - multiplier

So, for a 20-day moving average, it will be:

2/(20+1)]= 0.0952

Finally, we can calculate EMA for the current period. For that, we use the formula:

EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)

EMA for the most recent periods has more weight than EMA for longer periods.

Weighted Moving Average (WMA)

WMA is another important moving average that indicates a trade direction. This average gives more weight to recent data points and less weight - to more remote data points, just like EMA does.

WMA is calculated by multiplying a point in a data set by the weighting factor. The weight for points is distributed equally from 1% to 100% from the most remote to the most recent ones.

This moving average helps traders to determine what trend is in the market. When the prices are above the WMA, the market is in an uptrend. If the prices are below the WMA, the market is in a downtrend.

Double Exponential Moving Average (DEMA)

DEMA is a more accurate version of EMA. It allocates more weight to the recent data, thus reducing the lag. That’s why DEMA can be used by short-term traders to spot the reversal of a market trend asap.

To calculate DEMA, do the following:

• Select for which period you want to calculate it (a lookback period). It can be 5 periods, 10 periods, or any other lookback period.
• Calculate EMA for that time. This will be EMA(n).
• Now, apply the EMA with the same lookback period to EMA (n) - you get a smoothed EMA.
• Multiply two times the EMA(n) and subtract the smoothed EMA, and you get a value for the DEMA.

DEMA is not a double EMA, as you can think. It doubles the EMA but cancels the lag by subtracting a smoothed EMA.

DEMA is pretty straightforward. If the asset price is above the DEMA, and the DEMA is rising, it confirms the uptrend. If the price is below the DEMA, and the DEMA is falling, there is a downtrend.

DEMA is sensitive to market volatility and reacts to changes faster than the above-mentioned averages that’s why it is often used by day traders and swing traders.

Bottom Line

Moving averages help to identify the trend rather than give trading signals because they are lagging indicators. They shall be used with other tools, such as momentum indicators or price action to make correct decisions.