A moving average (MA) is everywhere. Not so obvious though these days, as the proliferation of sophisticated charting tools have meant that one does not often deal with the layers below the working of a technical indicator.
What do moving averages do?
On the face of it, a moving average unclutters a price reading. Market place being a venue for tug of war between bulls and bears that are often evenly matched, price charts rarely if ever show a straight line. In other words, price charts draw a picture of highs and lows against each time point. Plus, the open and close as well against each time point, depending what time of price chart you are using for analysis. No matter what, it is not very easy on the eyes, unless you are a seasoned trader. Even if you are, it is always better to have a way to smoothen out those highs and lows and all those volatilities and tell us, in general, where price is heading, or at which price point traders have set their eyes on. This is where the moving average comes in.
Playing around with MAs
MAs start to assume significance, when the averages are taken for different periodicities (like 10 minutes or 1 hour, or 10 days or 200 days, or weeks). Shorter periodicities give aggressive view about the price, meaning that the results thereof could be prone to false signals. Longer moving averages, on the other hand, are more stable, and therefore, more reliable, but the longer it gets, the fewer trade set ups are obtained, thus reducing the usability, especially to a trader.
Tune MAs to your liking
Moving Averages being a lagging indicator (meaning that they lag behind price, but serves as confirmation of a sign, that is sometimes obscure to the naked eye), it is important to give enough weightage to that lag when taking a price view on the basis of MAs’ position. Or a better way is to tone down the lag, by tweaking the formula of the MAs to give more importance to recent price changes. Then you get EMAs as they are popularly known, or Exponential Moving Averages. The impact of periodicities on EMA based analysis is not dissimilar from that MAs, or simple moving averages (SMAs). Just that they give faster signals than their SMA equivalent, being closer to price.
Mix and Match
Now that the fundamental make up of moving averages is understood, it will be interesting to know that several popular indicators are constructed by bringing in several MAs into play. For example, MACD, a very popular technical indicator is a plot of the difference between 26 period EMA and 12 period EMA. And then a signal line is plotted by taking the 9 period EMA of the MACD. It is the convergence or the divergence between the MACD and signal that forms the centre of MACD based analysis. Similarly, potential trading ranges can be found at 2 standard deviations away from a 20-day simple moving average. Yes of course, all these numbers are standard settings, and can be changed to suit the practitioner’s liking or purpose.
Technical Analysis is no magic. It is just a simplification of data. It becomes an art, when one is able to simplify it enough to take entry and exit decisions with a better clarity.