Moving Average – Types, Calculation, SMA & EMA
As the returns on bank FDs are dwindling, more people move towards the stock market as an investment option. So it is important to understand multiple terminologies & concepts before you start investing.
Investors often perform in-depth research on any stock before investing. This analysis can be classified into two parts, viz. Technical Analysis & Fundamental Analysis
Technical analysis deals with the study of multiple indicators & charts. In contrast, Fundamental analysis deals with the company’s fundamental like its Profit ratio, balance sheet, debt, PE ratio and much more.
In this blog, we will be talking about Moving Average. It is one of the many technical indicators that are vital for speculating the movement of stock.
Let’s get going.
What is Moving Average?
The Moving Average is the average price of any stock over a certain period. It is one of the primary indicators that eliminates random price fluctuations in the stock. It offers a clear understanding of the stock’s price movement over the period. It also helps in determining the Resistance levels & Support levels.
The moving average can be calculated in multiple ways & over multiple periods for, e.g. 30 mins, 1 hr, 4 hrs, one week or 30 days. In short, this technical indicator can be tailored as per the need of the investor or trader.
Once the CMP (Cash Market Price) of the stock crosses the Moving Average Line, a buy or sell signal is generated. This can offer an excellent investment opportunity at the right time.
Types of Moving Average
The Moving Average can be classified into two types, viz.
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
Simple Moving Average (SMA)
A Simple Moving Average is an average of the closing price of the stock over a specified period. This technical indicator is a simple yet effective tool to understand whether the price will keep up its momentum or it will see a trend reversal.
How is the Simple Moving Average calculated?
A 10-days SMA is calculated by adding the closing price of the stock at the end of each trading day & divided by 10. This will get you the first data point. For the next data point, the closing price of another 10-days will be calculated and divided by 10.
As the new closing price is available at the end of each trading day, the 10 days-SMA moves forward. It is important to note that all the data points are weighted equally. This means it is possible that SMA might not give an accurate signal as per recent trends.
SMA = (A1 + A2 + A3 + ……….An) / n
Why is SMA important?
- SMA gives a clear understanding of the trend by eliminating any random price fluctuations.
- SMA helps traders in generating entry & exit signals quickly.
- When the SMA is moving downwards, it shows the down-trend & there is a possibility that the price will go down further. On the contrary, if the SMA shows up-trend, there is a possibility that the price will go up.
Exponential Moving Average (EMA)
The concept of Exponential Moving Average is similar to that of Simple Moving Average. The only difference is, unlike SMA, where all the data points are weighted equally, in EMA, the most recent data points have more weightage & as you go back in time, the weightage reduces.
In simple words, EMA offers a better insight into the recent price-action of any stock than SMA. Like SMA, EMA is used to generate buy or sell signals, depending on the share’s price-movement above or beyond the EMA.
How is the Exponential Moving Average calculated?
EMA give average value closest to actual price value as compare to SMA. EMA moves quickly and calculation of EMA is complicate than other moving averages.
EMA = Price today x ((Smoothing/(1+Days)) + EMA yesterday ((1-(smoothing/(1+Days))
Why is EMA important?
- EMA is generally used as a supportive technical indicator.
- Traders generally combine EMA with other Technical indicators to speculate price movement efficiently.
- Combined with the strong Market movement, EMA can be of great help, especially for intraday traders.
But as it gives more weightage to the recent price trends, it is a lot less smooth than SMA.
SMA & EMA both are lagging indicators. This means they generally give a signal after the time of entry or exit has elapsed. So it is essential to analyze Market trend & use SMA & EMA as Supportive indicators. Any wrong move & it can cost investors & traders dearly.