We had discussed some of the basic technical analysis tools in our previous lessons such as up trendline, down trendline, support and resistance. The moving average gives buy and sell signal at the apt juncture that can be used by traders and investors alike to take or pare positions.
With the recent preoccupation among our analyst fraternity with the moving averages in general and 200-day moving average in particular, most of us would like to know what a moving average is. As we all know, an average is the middle value for a set of data. Since the value of the moving average line is calculated afresh for a pre-determined period with the latest data, the average “moves” over time. The moving average line helps in smoothing the data and points towards the underlying trend in the chart. Moving averages is a trend following and smoothing tool.
There are numerous types of moving averages. The more popular are the simple moving average and exponential moving averages (or exponential weighted moving averages). To construct the simple moving average or arithmetic mean, the required values for a particular period is taken and its average is calculated. For a 20-day moving average, the latest 21-days values are taken and its average is calculated by adding all values and dividing it by 21. Refer to chart 1 depicting Bongaingaon Refinery for a 21-day simple moving average.
To construct the exponential moving average (EMA), the latest data is multiplied by an exponential percentage thus giving greater weight to the most recent data. The formula for an exponential moving average is:
EMA (current) = [(Price (current) – EMA (previous day)) x Multiplier] + EMA (previous day).
Multiplier = 2 / (N + 1)
A “Multiplier” is used to express the degree of weighing decrease, where N is the specified number of periods. The exponential moving average is more sensitive and moves very close to the stock price, as the greater per cent of weight is given to the most recent data. As we can see from Chart 2 depicting 21-day exponential moving, the line moves much closer to the price than a simple moving average.