You feel feverish and visit a doctor. Your doctor pulls out your medical records to understand your health better. He places his stethoscope on your chest, takes your temperature, check your throat and so on. Finally, he comes up with a diagnosis and prescribes you the appropriate medicine.
Indicators show the health of any stock. They can tell you if the stock is overvalued, undervalued or at fair value. They can also guide you on the stop loss and profit target zones.
Most indicators are derived from prices. Volume is one exception. To save yourself from analysis paralysis, avoid putting 5 or more of them on your charts.
Let’s cut through the fluff and present the most widely used indicator – the moving average.
Moving Average Explained
What is it?
A moving average (MA) is a moving line that shows you the average price over a certain period. You can choose the time period you want.
The most common period parameters are 20-, 50-, and 200-day. Why? On a daily MA, there are approximately 20 trading days each month; 50 trading days in 2 months; and 200 trading days in a year.
So, if your trades tend to be short to mid-term, you will pay more attention to the 20- and 50-day MA, while long-term traders will watch the 200-day MA.
What can it be used for?
- Tell the trend
- Dynamic support and resistance
By knowing the trend direction (up, down, or sideways), you can form a bias to go long, short, or stay out.
MA can also be used as a dynamic support and resistance level. This will provide you with an idea on the price level you should enter.
You will learn about the trading strategies using MA in Part 2.
Types of Moving Averages
There are 3 types of Moving Average.
#1 Simple Moving Average (SMA)
#2 Weighted Moving Average (WMA)
#3 Exponential Moving Average (EMA)
A visual comparison of a SMA and EMA can be found in our Glossary.
Geek Speak (skip this section if Math gets you dizzy)
#1 Simple Moving Average (SMA)
This is the average price over the past N days (including today).
Where N is the Number of periods; and Pn is the last day of the period.
#2 Weighted Moving Average (WMA)
This form of MA places a heavier weightage to the more recent prices. This is because recent prices are more relevant.
Where N is the Number of periods; and Pn is the last day of the period.
Let’s say you decide to allocate a weight of 0.067 for Day 1’s price and add on another 0.067 for Day 2, and yet another 0.067 for the next day’s price. Over 5 days, the total weight will add up to 1.
Here’s a table representation.
#3 Exponential Moving Average (EMA)
EMA also gives a higher weightage to recent prices. but the difference in weightage between one price and its next price is exponential.
The calculation of EMA includes SMA. You’ll need to apply Formula #1 to get the 1st EMA. Next, you apply Formula #2 to get the rest of the EMAs.
Here’s Formula #1
Where t = today;
k = 2 / (number of days +1)
y = yesterday
Here’s Formula #2
Where t = today;
k = 2 / (number of days +1)
y = yesterday
Using the same set of prices, here’s the 5-day EMA in a table format.
Ok, that’s enough of geek speak.
You don’t need to memorize any formula. I hear your huge sigh of relief.
All you need to do is to add whichever type of MA you want onto your chart. It’s that simple!
Things You Must Remember
MA is the most widely used indicator as they help tell the trend and act as dynamic support and resistance.
The difference between the 3 MAs is tiny in the short-term. When used in the mid or long-term (ie 50- or 200-day), the difference is magnified.
Come back next week for Part 2 where I will share with you the different strategies and evaluate them.
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