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A tool that investors commonly use to determine the direction of a trend is the moving average. It shows a summary of the data points of financial securities over a specific time. Similarly, it calculates the average for it by dividing the total by the number of data points. The reason it is called moving average is that it continuously changes because the average is recalculated based on the latest price data.
In investing, a moving average is common when it comes to the technical analysis of a stock. Investors use it to help smooth out the price data by calculating an average price continually. It eliminates the impact of any random or short-term fluctuations in the price of a stock over the specified time. Similarly, investors can use the moving average to identify support or resistance by evaluating the movements in a stock’s price.
Types of Moving Averages
There are two main types of moving averages that investors can use. These are as follows.
Simple Moving Average
The simple moving average, as the name suggests, is a basic type of moving average. It only considers the recent data points in a given set and divides the total by the number of time periods. Investors use it to determine when to enter or exit a market. Simple moving average only considers historical data. Investors can calculate it for different types of prices, i.e., low, high, open, and close.
The formula to calculate the simple moving average is as follows.
Simple moving average = A1 + A2 + … + An / n
In the above formula, ‘A’ represents the average for each period, while ‘n’ denotes the number of periods.
Exponential Moving Average
The exponential moving average is more complicated compared to the simple method. It gives more preference to the most contemporary price points to make the moving average more responsive to them. Therefore, it is more responsive to the recent price change in the market. However, calculating the exponential moving average requires more work.
To calculate the exponential moving average, investors need to start with the simple moving average for the period. Similarly, they need to calculate the ‘multiplier’ for weighting the exponential moving average using the formula: [2 / (selected time period + 1)]. Using those, the investor can calculate the current exponential moving average. The formula for the calculation is as below.
Current Exponential Moving Average = [Closing Price – EMA previous time period] x Multiplier + EMA previous time period
Why is Moving Average important?
Moving average is a crucial concept in capital markets for technical analysis of the prices of a stock. Using moving average, investors and analysts can identify any trends in them. They may also use the moving average as lagged indicators as it uses historical information and, therefore, the averages cannot exceed the closing prices. Lastly, moving averages also assist in the calculation of support and resistance level in technical charts.
Conclusion
Moving average is a tool used by investors to define the direction of a trend. There are two types of moving trends that they can use, the Simple Moving Average and the Exponential Moving Average. Both of these produce different results. Overall, moving averages have significant importance, as discussed above.
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