Before we jump into the calculations of how the traders of the world compute and use moving averages in their daily trading let’s first see a few charts with these averages laid out.
This is a beautiful daily chart of Axisbank with a 21 period EMA (exponential moving average), do you see that upward trajectory and the fact that price came down to the blue line (that’s the EMA) and then continued it’s movement upward?
This is BharatForge, it’s moving swiftly up and as we can see the 21 EMA proves to be crucial support when the market ‘dips’. It works pretty well right? Well, like almost everything in the market the moving averages have a good and a bad. Let us start with the SMA or the simple moving average.
You live in much easier times than the generation of traders before us. In the times before us traders used to plot a chart by hand, taking each day’s closing price and recording it in a diary. After they had enough data they would draw a line to ‘average’ the movement of the stock over a certain number of days.
Today with the advantage of technology our customers at Upstox can use their NEST trading software and obtain a chart with their desired moving average within a few clicks (shown at the end of this article). Lucky you?
To calculate a 21 day simple moving average, simple add the closing prices of the last 21 days and divide by 21. This ofcourse gives us a single average point. When a new day is added then we have 2 points, and the calculation is done everytime a new data set arises, eventually making a blue line you saw in the charts above. If you were wondering why we call this a “moving” average and not just mean of prices it is because as new days are added, previous data sets are dropped to include the new data and the average is constantly ‘moving’.
The moving average is not restricted to only daily charts, they can be used on any timeframe and are useful for intraday traders as well as investors simply by changing the timeframe. For instance intraday traders may look to buy the cross over of the 10 period and 20 period average on the 10 20min timeframe while the investor may look for some buying pressure to arise at the touch of the 200 MA on the daily charts.
The Birth of The EMA
Now, If you think about it the simple moving averages gives the same ‘weight’ or importance to each new data point equally. Many traders asked themselves why older price points were given the same weightage as new price points in the simple moving average. Traders started to argue that the most recent development has the right to influence our averages more than the older data points.
Thus, the EMA was born, it gave more importance to recent data and the most popular variant is called the Exponential Moving Average (EMA).
Current EMA= ((Price(current) – previous EMA)) X multiplier) + previous EMA.
The most important factor is the smoothing constant that = 2/(1+N) where N = the number of days.
For example the smoothening for a 10-day EMA = 2/( 10+1) = 18.8
That means a 10 day EMA gives 18.8% weightage to the most recent data. The same way a 20 day EMA will give about 9.5% weightage to the most recent data.
The EMAs and SMAs are not efficient indicators, they provide a way to check what the masses are looking at and may give us an indication for trend changes. The key points to remember when using the moving averages are:
Couple it with price action
It is vital to use averages with strong price action methodologies which have shown results independently. The averages work well as a confirmatory indicator rather than a leading indicator.
Use Money Management
Unfortunately a lot of traders concentrate too much time on price discovery methods and not as much time on their risk management. Please make sure you are not leveraging too much by risking no more than 0.5% or 1% per trade for beginners and slightly more for the more experienced.
Averages + Trading Methodology = Win
At the end of the day you are basically looking at the average movement of price, use a tested methodology to trade the averages. Discipline and methodology are your main ingredients to successful trading.
Now that we have talked about the pitfalls, we will be exploring some ideas of using the averages for our trading!