A Quick Recap…

In our previous article, we covered the basics of moving average. To give you a quick glimpse, moving average is an indicator used to get a comprehensive idea of the trends in a dataset. It adds up the stock price over a specific period and then divides the summation by the total number of data points to get the average.

The reason it is called a ‘moving’ average is because it is continually recalculated based on the latest price data.

We also discussed two types of moving averages: simple and exponential. Read our previous article for a detailed introduction.

Now, let’s come back to how moving averages can be used in trading.

We illustrate some instances for you:

1. Determining trends using MA

The direction and position of the moving average gives us crucial information about the price trend of a stock. If the price of the stock is increasing, the moving average rises; whereas, if the price of the stock is declining, the moving average falls.

A price placed above the long-term moving average reflects an overall uptrend, whereas a price placed below the moving average reflects an overall downtrend.

If the stock price rises above its moving average, a ‘buy’ signal is established, whereas when the stock price has dropped below its moving average, it generates a ‘sell’ signal.

In the below picture, we can see the chart of ICICI Bank with the time frame of 1-Day. We have used the 10-day EMA (Exponential Moving Average) for our analysis. When the stock price is above the moving average line, a ‘buy’ signal is generated, and it is the ideal time for a trader to enter a position. Similarly, when the price falls below the moving average line, a ‘sell’ signal is generated and it is a good time to exit.

2. Determining support and resistance using Moving Average:

Moving averages can also determine support and resistance. If there is an uptrend in the stock, long-term moving averages such as 50-day, 100-day, or 200-day act as a support level.

This is because once the price of stock touches the moving average line, there is a high chance of it bouncing back. Similarly, during a downtrend, a moving average acts as a resistance level. Here, the moving average acts as a ceiling, and if the price hits this level, there is a high chance of the stock price dropping.

Let us understand this concept with the help of an example. In the below picture, we can see the chart of Wipro Limited and the time frame is 1 day.

The moving average used for the analysis is the 100-day SMA. When there is a downtrend, the moving average acts as a resistance. After consolidation for a few days at the same level, the price declines.

On the contrary, when there is an uptrend, the same moving average line acts as a support, and once the stock price reaches the support level, it bounces back.

3. Identifying the crossover

The crossover forms when two different moving averages cross each other. Primarily, two types of crossovers are used in trading: the golden cross and the death cross. In both these crossovers, one moving average is for a shorter duration, while the other is for a longer duration. Generally, 50-day and 200-day moving averages are used to identify these crossovers.

In a golden cross (bullish signal), a short-term moving average crosses above a long-term moving average, whereas in a death cross (bearish signal), the short-term moving average passes below the long-term moving average.

Let us understand this concept with the help of an example. In the below picture, we can see the chart of TATA Motors Limited with a time frame of 4 hours. Also, for our analysis, we use the 50 and 200 SMA.

The death cross forms when the short-term moving average (50 SMA) crosses below the long-term moving average (100 SMA). After the formation of the death cross, the price of the stock declines sharply. Therefore, we can say that most of the time, the death cross shows that there is the potential of a massive sell-off.

Also, in the later part of the chart, we can see the formation of a golden cross. This forms when the short-term moving average (50 SMA) passes above the long-term moving average (100 SMA). After the formation of the golden cross, the price of stock has increased gradually. Therefore, we can say that it is a good time for the trader to buy the stock.

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Moving average is one of the most common indicators used by traders. It is an easy-to-use statistical tool primarily used for forecasting trends.

Let us understand the basic definition of moving average.

Moving average is an average of any subset of numbers. In trading, it is an average of closing prices within a time frame and is used for predicting future trends.

Because the moving average is based on past prices, it is a trend-following or lagging indicator. Further, what makes it more dynamic is the customization it offers.

Any time period (such as 15, 20, 30, 50 days) can be chosen by the trader while calculating the moving average. Sensitivity to price changes can be regulated by changing the time period. If the period is short, there will be more sensitivity to price change, and vice versa.

An intraday trader prefers a shorter-term moving average, whereas swing traders prefer longer-term moving averages.

Trend analysis Using Moving Averages

A rising moving average shows that the stock is in uptrend, whereas a declining moving average confirms a downtrend. Further, traders use two different moving averages to decide whether there is upward momentum or downward momentum in the stock price.

When a short-term moving average crosses above a long-term moving average, a bullish crossover forms (known as golden cross), which confirms that there is an upward momentum.

Similarly, if a short-term moving average crosses below a long-term moving average, then a bearish crossover is created (known as death cross), which confirms downward momentum in the stock.

Types of Moving Averages:

There are two types of moving averages: Simple moving average and exponential moving average.

A) Simple Moving Average

A simple moving average or SMA is an arithmetic moving average calculated by adding the recent prices and dividing the summation by the number of time periods in the calculated average.

Let us understand SMA with the help of an example:

The table above shows the closing price of a stock for 7 days. While calculating the SMA, the first 5 days’ values are considered. Here, the SMA comes out to be 7. Similarly, while calculating the next SMA, the Day 1 value is excluded, and the Day 6 value is considered to calculate the SMA value. Finally, the Day 3 value is excluded and the Day 7 value is taken to calculate the SMA.

Exponential Moving Average

Exponential Moving Average or EMA gives more weight to the most recent price data, which is considered more relevant than older data.

There are three simple steps that are followed in calculating EMA:

1. First, the SMA is calculated. Suppose you want to use 5 days as the number of observations for the EMA. Then, you must wait until the 5th day to arrive at the SMA. On the 6th day, you can then use the SMA from the previous day as the first EMA for yesterday.

II. After this, the multiplier (k) for weighing the EMA is determined.

Multiplier (k): [2 ÷ (number of observations + 1)]. Here, the number of observations = total time period. Taking the previously discussed example, number of observations = 5. Therefore, the multiplier in this case is k = 2/ (5+1) = 0.33.

III. Finally, the current EMA is calculated.

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

Generally, 12-day and 26-day EMAs are used to identify short-term trends, whereas 50-day and 200-day EMAs are used to identify long-term trends.

Sensitivity to recent price point changes is more in EMA compared to SMA, making it more responsive to the latest price changes. We can observe how quickly EMA responds to price changes compared to SMA from the below graph.

This feature of EMA makes the results more timely and accurate, thus explaining why many traders prefer to use this indicator for trading.

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