Moving averages, which plot the average value of a security’s price over a specified period, usually 20, 50, 100 or 200 days, are perhaps the most popular and commonly used tool in technical analysis.
They measure momentum, spot trends and define areas of support and resistance.
Because moving averages are based on past prices and are therefore lagging, they do not determine price direction but establish a current direction, flattening out price fluctuat-ions and signalling potential entry and exit points.
The two most common types are the simple moving average (SMA) and the exponential moving average (EMA).
Moving averages may vary in the way they are calculated and may differ in respect to how price data is weighted, but their interpretation remains the same.
A simple moving average is constructed by calculating the average price of a security over a specific number of periods. Generally, closing prices are used in computing moving averages.
For example, in a five-day moving average, the last five closing prices are added together, then divided by five.
The average then moves on to the next day, and old data is dropped as new data arrives.
If a security’s daily closing prices were 21, 22, 23, 24, 25, 26 and 27, the first day of the five-day simple moving average would be 23 (21+22+23+24+ 25/5 = 23), the second day would be 24 (22+23+24+25 +26/5 = 24) and so on.
The exponential moving average places a higher weight on recent data points, thus reducing the lag factor.
It’s also much more responsive to new information, and so is favoured by investors.
EMA calculations are complex, but there are programs that can readily perform them.
Moving averages are typically used to identify whether a security is in an uptrend or a downtrend, depending on the direction of the moving average.
In the chart below, both the 50-day SMA (red) and EMA (green) peaked in January, the EMA with a more pronounced decline. The price of the security kept falling, so the moving averages signalled a downtrend.
In February, the EMA turned up, signalling an uptrend, but the SMA lagged and moved up a month later.
The EMA has less lag and generally turns before the SMA.
As the SMA represents an accurate average of prices for the entire period, it’s best suited to identifyíng support and resistance levels.
Anthony Galliano is the chief executive officer at Cambodian Investment Management.