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What are Moving Averages in Stock Market? – Overview, Types, and Examples

What are Moving Averages in Stock Market? - Overview, Types and Examples

Moving Averages in Stock Market

While we are trying to discuss the tools and indicators for technical analysis, let’s check out the most commonly talked about the indicator. In today’s article, we will discuss “What are Moving Averages in Stock Market”.

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What are Moving Averages in Stock Market?

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To study the direction of a trend, moving averages is the most commonly used technical analysis indicator. As the name suggests, it smooths out the price data by adding all data points over some time and then dividing by the no. of the data point. Now you must have a question about why it is called moving averages because it is constantly adjusted using the most recent pricing data.

Moving Average indicates the direction of the price trend. Therefore, if there is an upward trend then it signifies the price is moving up or there is upward momentum in the security. This indicator is used by traders to determine whether there is a shift in momentum for a security, such as if the price of a security drops suddenly. Using moving averages in the stock market, traders can support their assumptions that a shift is going to take place.

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Example of Moving Averages

To understand the concept of moving average most simply. I would suggest using excel while analyzing the historical price data. It depends on the period of data you wish to analyze. Usually, traders use 7 days, 28 days, 50 days, or 240 days moving average to study the trend. The narrower the period used to calculate the average, the more sensitive it is to price changes. Over a longer period, the average will become less sensitive.

To make you understand in layman’s language I will pick the last quarter data for HDFC Bank stock and use the most commonly used formula Averages in excel using 7days moving averages, similarly, you can take the average for any period which you think would be right for you to make a decision.

With the help of the above chart, we can make out 7-day moving average is more sensitive to a price change as compared to 28 days moving average.

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Types

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Well, there are many types of moving averages used by traders to determine the direction of the trend. We will discuss a few of them with examples. Let’s deep dive into each one of them in little detail:

Simple Moving Average

It is the simplest form of moving averages. Just need to add all data points and divide the same by the. of data points. A basic understanding of the moving average explained above will be applicable here. It’s a lagging indicator as it’s derived from past data. Not only helps in determining the entry and exit point in the stock. But also it helps in figuring out support and resistance level.

Crossing of trading prices signals is frequently triggered by SMAs. When prices cross above the SMA, you should consider going long or covering short; when prices cross below the SMA, you should consider going short or exiting long.

Exponential Moving Average

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In exponential moving average, we give more weightage to recent price data points to make them more responsive to new information. For calculating the exponential moving average, you need to simply calculate the simple moving average and then calculate the multiplier for weighing the EMA. using the simple formula:

S=2/ (Chosen time period+1)

This multiplier is also referred to as a smoothing factor. Further, we can calculate yesterday’s EMA and this will simplify the entire process:

EMA= S*(C-P)+P

Let’s choose 20 day period for calculating EMA for the same set of HDFC Bank data. Using the above formula, we could plot the values on the chart something like this

From the chart, it’s clear, that EMA stresses more emphasis on recent data points and thus detects the trend faster than SMA. It is quite useful to predict rapid fluctuation. In other words, If the EMA line is above the stock price, there are chances it is likely to fall next. However, if the price level is above the EMA line, it indicates that the value of the stock will be going to increase further. Thus, investors can easily identify the buy and sell signals using EMA as an indicator.

Weighted Moving Averages in Stock Market

It’s another type of moving average in which you give more weightage to recent data points and less weightage to older data points. It is calculated by multiplying the weightage factor with respective data. Further, adding all data points divided by no. of all data points.

In case the prices are above the weightage moving averages then it signifies a bullish run or else it’s bearish. Let’s say the price of the stock for 5 days period is 1469.95,1476.4,1452.95, 1432.9 and 1431.75

Usually, the weightage factor is determined by the period selected for the indicator hence in this case it will be calculated like this:

Weighted Moving Average= 1469.95/5+1476.4+1452.95*3+1432.9*2+1431.75*1/ (5+4+3+2+1)

= 21911.75/15 = 1460.783

Also Read What is 200 DMA in Stock Market?

Bottomline

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Some argue that an exponential moving average (EMA) is a superior trend indicator than a WMA or SMA since it uses an exponentially weighted multiplier to give greater weight to recent prices. The EMA, according to some, is more responsive to changes in patterns. However, SMA helps locate simple support and resistance regions on a chart because of its more basic smoothing. Moving averages, in general, smooth price data that is otherwise visually noisy. Therefore, there will always be a lag in the timer period. It depends upon the trading style of the trader which one he can analyze quicker to study the trend.

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