Using Moving Averages As Technical Indicators
The moving averages are lagging indicators that most traders both professional and novice, will have probably used at one time or another.
Although there are a number of moving averages indicators, the most common used are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
In this article, we will focus on these two indicators which traders use as technical indicators to forecast market trend movements to make their decision in trading.
These moving averages will help identify:
1. Direction of a trend.
2. Potential support and resistance levels.
The Simple Moving Average (SMA)
The simple moving average (SMA) indicator is the most basic of the moving averages used as a common indictor for trading. It is calculated by taking the closing price of the asset and adding it with a number of time periods, and then dividing it by the total of number of the time periods.
For example, let’s say the last 5 days closing prices for Kuala Lumpur Index Futures (FKLI) are 1300, 1450, 1250, 1500 and 1550.
Thus, the 5-day SMA for FKLI is calculated as follows:
1300 + 1450 + 1250 + 1500 + 1550 / 5 = 1410
The way of looking at simple moving average is straight forward. If the simple moving average line is on an upward trend, it indicates a strong momentum of an upward trend.
If the simple moving average line is on a downward trend, it indicates a strong momentum downwards.
If the simple moving average line is neither up nor down, it indicates a weak momentum where the market is stagnant.
The momentum also builds if the shorter term SMA crosses over the longer term SMA. In the illustration below, the 15-SMA crosses over the 50-SMA indicating a strong upward trend momentum.
The simple moving average can also be used as a support on an upward trend and also a resistance on a downward trend. The illustration below shows the simple moving average line as a support and resistance levels.
The con of using the simple moving average (SMA) is that some regard it as a lagging indicator since it does not weight recent price movements. Thus some traders prefer to use the exponential moving average (EMA) which will be discussed below.
Exponential Moving Average (EMA)
The exponential moving average (EMA) is similar to the simple moving average (SMA) just that more weight is given to the data. In this manner, the average is weighted to place emphasis on the most recent price action.
This is the reason why many traders prefer to use this indicator because of its ability to reduce lag between EMA crosses.
The EMA is read exactly like the simple average price movement where the upward trend of the EMA line indicates a strong upward trend momentum and vice versa.
Like the SMA, the momentum builds if the shorter term EMA crosses over the longer term EMA. In the illustration above, there 3 examples of which the shorter term 50-EMA crosses the 200-EMA to indicate the trend.
1. The 50-EMA crosses the 200-EMA on an upward trend to give the price trend an upward momentum.
2. The 50-EMA crosses the 200-EMA on a downward trend to give the price trend a downward momentum.
3. The 50-EMA crosses the 200-EMA on an upward trend to give the price trend an upward momentum. From here you can notice that the 50-EMA and 200-EMA do not touch indicating a continuous upward trend.
Simple Moving Average (SMA) versus Exponential Moving Average (EMA)
There are distinct differences between these two indicators as discussed above and both of them have different functions as indicators.
Because the exponential moving average has less lag, traders prefer to use this as a trend indicator.
However for simple moving averages, it represents the true average for the entire time period. Thus, the SMA may be more suited to identify support and resistance levels.
Other Indicators in Technical Analysis:
- Average True Range (ATR)
- Bollinger Bands
- William %R
- Moving Average Convergence Divergence (MACD)
- Relative Strength Index (RSI)
- Commodity Channel Index (CCI)
- Fibonacci Fan
- Retracements and Trend Reversal
- Support and Resistance
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