Lets get straight into moving averages:
The moving average indicator
The moving average is a lagging indicator used by traders to confirm the existence of a trend over a predetermined number of periods.
Simple moving averages (SMA)
The formula:
SMAn = ( price1 + price2 + … + pricen ) / n
An example:
Prices | |
Monday | 10 |
Tuesday | 12 |
Wednesday | 13 |
Thursday | 9 |
Friday | 11 |
SMA5 Friday = | 55 / 5 = 11 |
For a worked example please go to the lesson materials section.
How the SMA reacts to price
When a new period’s price is recorded the oldest piece of data is removed from the calculated, remember the formula is looking at a set number of periods.
SMA5 Friday | SMA5 Monday | |
Monday | 10 | – |
Tuesday | 12 | 12 |
Wednesday | 13 | 13 |
Thursday | 9 | 9 |
Friday | 11 | 11 |
Monday | – | 25 |
SMA5 | 55 / 5 = 11 | 70 / 5 = 14 |
This has the effect of smoothing price action. The more periods in an SMA calculation, the more it will smooth the price action. In practice, it is a balancing act for traders: too few periods and there is too much noise, too many periods and confirmation being sought will take too long.
Limitation of the SMA
The SMA weighs each data point equally, in practice traders place more weight on the most recent prices.
- The moving average is a lagging, trend following, indicator.
- Traders use it to confirm the direction of the trend.
- When adding a moving average indicator, traders set how many periods they want it to look back over.
- Moving averages smooth out the price action.
- Because each period is weighted equally, the SMA formula places the same weight on the first and last periods.