One of the most popular methods used by traders in determining the trend of a certain asset or stock is the moving average. Moving average simply shows the potential change in the trend of the price considering the previous movement. Mathematically speaking, it is the last period’s closing prices added together and then the sum is divided by the number of observed period.

The moving average is a great tool to gauge the strength and potential of the momentum of an asset and to predict the possible support and resistance. For instance, you just have to plot as single moving average on the chart, then if it surpasses the moving average then the stock will likely turn bullish. On the other hand, if the price stays below the moving average, then it could be a bearish call for the stock. (See figure 1)

However, do not be deceived in plotting just one. It’s better to have at least two or three to fully examine the reliability of the trend.

Types of Moving Average

There are two types of moving average, simple and exponential. Simple moving average is like the mean of the price within a chosen period. For example, if you wish to know the SMA on a 1-hour chart with a 10 period, simply add the closing price for the last 10 hours and divide it by 10. The answer would be the simple moving average.

Here’s how SMA is greatly used. In the article APPL Stocks Up Despite Irish Tax Issues? It showed that “On August 30, it traded from 106.49 to 105.56. The range is above its 50-day (101.95), 100-day (100.42) and 200-day (102.61) SMA. Although it is considerably lower than yesterday’s trade, it seems that on August 19 its 50-day and 100-day SMA has changed positions, indicating an uptrend.” For this kind of equity, a longer span or period is usually taken into consideration.

Another type of moving average is called exponential. Exponential moving average let the traders pay attention in the previous prices. In the chart below, Boeing had an SMA of 130.754. Day 1 – 132.78; Day 2 – 130.68; Day 3 – 129.52; Day 4- 129.65; Day 5 – 131.13. The result would mean that the price was about to go down. However, if you would consider the closing prices for the three consecutive sessions you may predict an upside. This technique can provide a reasonable trend for the stock. Remember that in short term trading, it makes sense to consider the recent price movement.

The risks for SMA include the chance of  lagging signals. It is much slower than the EMA, whereas EMA could provide price fake outs and errant signals since the price movement and the moving average changes quickly. Here’s the secret. If you are a trader who avoids fake outs and can endure slow signals, then go with SMA. If you are one of those who prefer quick trends despite the risks involved, then choose EMA. In some cases, you may use both.

Common SMA

Hyper traders usually use 5-SMA while short term traders choose 10-SMA and 20-SMA.  Traders who wish to measure the medium-term trends prefer the 50-SMA and long term traders use 200-SMA.