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Moving averages are one of the most basic yet the most widely used technical indicators. So what is a moving average? Put simply a moving average is the average of the closing price of the stock, the currency pair or any other security calculated over a certain period of time. Moving averages help you determine the trend.
There are a number of moving averages that you can use. However, you should know that the selection of the timeframe you use when you calculate the moving averages is very important. Timeframe of the moving average depends on the number of closing prices that you want to include in the calculating the moving average.
Suppose your trade lasts only for a day or two or even less than a day, in such a case a 5 day time frame though very short term is appropriate. On the other extreme, if you are a long term trader and are in the trade for months than you might use a 200 day moving average. So pick a time frame that is appropriate to the amount of time that you intend to have the trade on.
Simple Moving Averages
The most basic type of moving average is the simple moving average. It is very easy to calculate and is the most common of the moving average used by the traders. So if you want to calculate the 5 day moving average just add the 5 closing prices of the stock or currency pair for the last 5 days and divide it by 5 to take the average.
Always remember the longer you timeframe for the trade, the longer the moving average that you need. Now the two other variations to the simple moving average is the Weighted Moving Average and the Exponential Moving Average.
Why would a trader want to calculate more complex moving averages? The major advantage of using these complex moving averages is that they tend to show the change in the trend more quickly than the simple moving average. Detecting trend changes fast can help you make more profitable trades.
As a trader, you know that most recent price action is more important than distant price action. A simple moving average gives equal importance to all prices. In order to overcome this shortfall, weighted and exponential moving averages have been calculated that give more weight to the recent price action.
Weighted Moving Averages
A weighted moving average is calculated by multiplying the most recent price with the number of prices in your time frame adding it to the second most recent price multiplied to the total number of prices in the timeframe minus one and so on till you reach the oldest price in the list then divide the total sum by the total number of prices in the timeframe. Sounds complicated huh?
Exponential Moving Averages
Exponential moving averages give a lot of emphasis on the recent price action as compared to the weighted moving averages. Exponential moving average is even more complicated but you don’t need to calculate these moving averages, the charting package can do it for you. Just select the time frame!
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