You Cannot Proceed Without Moving Averages

By | September 17, 2013

Tueday, September 17th, 2013 by James Franklen

If you are new to options trading, a single look at the price candle chart will make you dizzy. Usually when trading live, you are immediately offered a live chart, with minimum timescale, that is, you see price candles for every 15, 5 or 1 minute. You would be able to see very short-term trends in these bars, prices going up for a small span and then going the other way in the very next span.

The question that arises is, how do you make it all understandable? How you are supposed to make out strong trends, how far behind should you go? With a little research you would know how far back in time you have to go, and in which pairs to get meaningful trend formations. Still you would lack the clear sight of the trend, and moving averages exactly do this thing.

Moving averages smooth out the price data. It clears all the mist of ups and downs and shows you the exact trend. Bear this in mind that moving averages do not predict the direction of the price; rather they explain to you the current course and that too with a lag. More importantly, they are the building blocks for other types of technical analyses such as MACD or Bollinger Bands.

There are two types of moving averages, the simple moving averages (SMA) and the exponential moving averages (EMA). The SMA is simplest to calculate; you take the closing prices of last few days and divide them by the number of days of which you took the closing prices of. That’s SMA on a single day, to make them ‘moving’ you drop the closing price at the rear and instead include the closing price of latest day. The point to note here is that, the SMA takes effect of each price equally, it does not differentiate among them.

On the contrary, the EMA, also known as the weighted moving average, gives more weight to latest price and less to earlier ones. This way you include a higher impact of recent price changes. For an EMA, you need to decide on the exponent or the ‘smoothing factor’, which is 2/ (No. of Days + 1). The number of days is the period of EMA you want to have. After that you need the EMA, or if that’s not available, the SMA of “yesterday”, if you are calculating EMA “today”. The last thing you want to know is ‘today’s closing price.

So if you want to calculate 200 day EMA of a given asset, which has a previous day’s EMA of 110 cents and whose closing price for today is 130 cents, you would calculate it as follows:

Today’s Exponential Moving Average = Exponent X (Today’s/ Current Day’s Closing Price – Prior Day’s/ Yesterday’s EMA) + Prior Day’s/ Yesterday’s EMA.

= {2/(200+1)} X (130 – 110) +110

= 110.2

Once plotted on the price chart, the SMA and EMA can help you with identifying trends, explaining price movements or even tell you about supports and resistance.

One thought on “You Cannot Proceed Without Moving Averages

  1. jawad

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