Moving Averages

In this overview we will be looking at moving averages; more specifically the simple moving average and the exponential moving average. We will be defining both and show how these indicators can be used as every-day technical analysis tools.

Moving averages are a very popular tool amongst technical analysts. On a chart these averages will appear as a wavy line going through, above or below the share price depending on the share price movement. By their nature, moving averages smooth out the share price data and make it easier for the trader to identify short, medium and long-term trends.

Simple Moving Average (SMA)

This is simply the average share price. The average share price will be calculated over a time period that the analysts is interested in. For instance, for a short term trend a 15-day SMA is used, while for medium to longer-term trends the average share price might be calculated over 50, 100 or even 200 days.

Exponential Moving Average (EMA)

The exponential moving average is very similar to the simple moving average. Again, this is the average share price of the stock. The only difference to the aforementioned SMA is that the EMA applies weighting factors that decrease exponentially. In other words, this method gives much more importance to the more recent share price movements as compared to the older variations. Again, as above, the time period the EMA is calculated from depends on the type of analysis the analyst is doing.

There is very little difference between the two, however it should be pointed out that the EMA is consistently closer to the share price than the SMA. Some people prefer one to the other for personal reasons, that is, the SMA works better at a particular time period on a particular stock and vice versa for the EMA.

Example

The chart below is of the Commonwealth Bank (CBA), from November 2006 to early April 2007. There are two EMA lines below, the brown one is the 15 day EMA line, while the red line is the 100 day EMA line.

Yellow area – Notice here that the share price breaks below the 15-day EMA line before bouncing off the 100-day EMA line. The share price then pushed up through the 15-day EMA line and continued higher. The long-term trader would se the bounce off the 100-day EMA as a long-term share trade entry whilst the shorter-term trader would see the break through the 15-day EMA, confirmed by the long green candle just outside the yellow area (further supported by increasing volume indicator in the lower section of the chart), as an entry signal to go long.

Aqua area – Again here the share price fell below the 15-day EMA line before finding support on the 100-day EMA. As before, the share price then rose and broke through the 15-day EMA line before rising higher.

This technique works well in a trending market, however in a sideways moving market this method can be unreliable. As always, it is best employed with other indicators or analysis tools.