Simplifying what are Moving Averages – SMA & EMA: Moving averages are one of the simplest yet most frequently used technical analysis tools by traders. Every time you read any technical or research report, on any Index or shares of a particular company, you must have come across terminologies like the Simple Moving Average (SMA) or Exponential Moving Average (EMA). These are the two types of Moving Averages.
In this post, we discussed the basics of Moving Averages in the technical analysis of stocks. Here, we covered what are Simple Moving Averages (SMA) and Exponential Moving Averages (EMA) and how to use them correctly. Let’s get started.
An Example to Understand Moving Averages
In mathematics (or statistics), a moving average creates a series of averages of different subsets of the full data set in order to analyze data points.
For example, imagine in a game of Cricket, we want to analyze the performance of a bowler. Here, the parameter that we can use for our judgment is the number of runs conceded against every wicket picked. Let’s assume that we have the following data available for the bowler:
From the table above, the total runs conceded by the bowler over 9 innings is 445. Further, he has got 20 wickets against his name. Therefore, the average number of runs conceded per wicket will be equal to 445/20 = 22.25 runs conceded per wicket This is the simplest method that we can use for calculating the average.
A similar concept can be used while looking at the price movements of the shares. Through this article, we will try to understand the concept of the moving average and its implication while trading.
What are Moving Averages?
Moving averages are the most common and sought after form of technical analysis tools used while trading. These indicators are said to be lagging indicators, as is it is constructed with the help of the data presented as the end of day prices.
In order to understand this concept easily, let us take another example. Consider the following closing prices for the shares of Reliance Industries limited:
Now, a simple moving average (SMA) is a calculation that considers the average or arithmetic mean of a given set of prices over a specific time period. For example, the SMA or average price of shares of RIL over these five days will be equal to 9085/5 = Rs. 1,817
Next, imagine if the share price of RIL at close on 10/07/2020 is 1,800. Now, if the calculate the moving average again for the last five days, its value will change as the average price changes after accounting for new data. In other words, the average price changes as and when the value of underlying asset changes on day to day basis.
Further, the moving averages can be calculated for any time frame. It could be 5 minutes, 15 minutes, hours, days, weeks, and so on. Depending on one’s trading style and trading objective, one can choose the Moving Average charting pattern. If we are using 5 observations within the selected time frame, it is called 5 SMA, and if we are using 9 observations within the selected time frame, it is called 9 SMA and so on.
Now, the chart below is the daily chart of Airtel Limited. And we have plotted 50 Day Simple Moving Average on it.
Now, if you carefully analyze, the 50 SMA clearly bifurcates the chart in two halves. When the market is trading over 50 SMA, we see continuous buying momentum in the market and the bulls are having a tight grip on the market. And as and when the market comes below 50 SMA, we see selling pressure in the market and the bears are having higher say in the market. Overall, in simple words, it can be said that prices above SMA are considered to be bullish and below it are bearish.
Exponential Moving Average (EMA)
Exponential Moving Average (EMA) are slightly advanced and more trusted form of moving average. The main difference between EMA and SMA is the weightage given to each and every value under consideration.
Under EMA, the more recent values are given higher weightage, but in SMA, all the values are given equal weightage. For this simple reason, EMA is sometimes said to be a better parameter for trading than SMA. We will not be going to explain the calculation methodology of EMA in this article.
The chart below is the daily chart for HDFC Bank and the yellow line plotted is the 50 EMA
Fig: 50 EMA of HDFC Bank (source: www.kite.zerodha.com)
Now, before explaining the chart, the following rule has been set for the entry and exit of the trade. A position is entered when the current price crosses over 50 EMA and the position is held till the share price down not crossover or come below 50 EMA.
If we look at the chart, the 50 EMA in the chart above has given multiple entry and exit signals based on EMA. For example, if we look at Trade 1, the chart gave a long trade as the market came close to the EMA and it bounced back and gave a return of about 15% (not bad by any standards). And similarly, Trade 2 gave an entry near EMA and upon exit, it gave a return of near 7%.
Moving Averages: Key understandings
In this post, we tried to simplify the concept of moving averages. Let’s quickly summarize what we discussed here:
- Moving Average gives us simple and traceable buying and selling signals
- When the price is trading above a certain MA, it usually signals strength in the market and buyers are having more say
- When the price is trading below a certain MA, it usually signals weakness in the market and sellers are dictating in the Market
Moving averages are considered to be a reliable indicator while understanding the trend and market sentiment. One has to continuously keep using them to get a better hang of them and find a moving average that suits their trading style. One Golden rule which every trader must follow: “Always have a stop loss for your trades” Happy trading and Happy Learning!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!