Moving averages (MA) are probably one of the most frequently used technical indicators. It does exactly as it states: calculates an average over a specified period of time (that's what makes it moving.) If they aren't being directly used as an indicator, chances are they are incorporated into the formula of another technical indicator.
Moving averages can be used to smooth out the trendline (this is useful because of the day-to-day price fluctuations), illustrate momentum, trend direction, and can even be used to define areas of support and resistance. Downtrends in a MA occur when new lows are being formed daily. Upward trends occur when new highs are being made daily.
Simple Moving Average (SMA)
A SMA is a basic mean between closing prices over a specified period of time. As time moves on, the average can either remain the same, increase, or decrease. These newly calculated averages for each new day, are then plotted to form a nice and smooth curve. SImple moving averages can also be derived from daily highs, lows, or openings, but this is not very common.
Since it is a moving average over an "n" amount of days, calculations will be removed from the SMA as the "n" amount of days are surpassed in the formula. Thus, we derive a perpetually occurring "n" day moving average, on each new day.
Trader warning: Simple moving averages are a lagging indicator. If a price is trending upward, it will take some days time for the short-term moving average to crossover the longer-term moving average.
Reason: Because the ride up is a gradual process, and SMA is an even slower process since it is incorporating an "n" amount of days.
Exponential Moving Average (EMA)
As an attempt to neutralize this lag affect, an the EMA was created. As an indicator, the EMA line usually remains closer to the actual price trend than the SMA. An EMA achieves this by applying more weight to the latest price.
As shown above, when prices tend to be very volatile and erratic, EMA usually is closer to the price trend than the SMA. When prices slow, an SMA is usually closer to the price trend.
Since the EMA deviates faster than the SMA, most short-term traders tend to favor the EMA. In this respect, one can discover price changes more rapid.
Most investors use moving averages to follow trends, rather than predict trends. This is because a MA is calculated from a set of data from the past.
Here, a 50-day SMA is used to determine price resistance and supports. In the case of the investor who uses SMA to predict trends, when a price breaks the SMA resistance - buy. When a price breaks the SMA support - sell.
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