Another function that can be used on graphs for online trading is a moving average. The moving average is used extensively to analyse series of historical data and above all for technical analysis. This graph function can be set up on trading platforms (particularly those that we recommend) and there are typically three types to be found: simple, exponential and weighted. In this lesson we will look at the similarities and the differences between these three types of moving averages, without going into too much technical detail that you can later look into personally depending on your individual needs.
Simple Moving Average
A simple moving average (SMA) is also known as an arithmetic average and is by far the most used by analysts and those who trade in the markets online. With this moving average, the data used is from a determined period from which the average is calculated by simply adding values together and dividing the total by the number of values used (eg: 3+5+6+8 and divided by 4). The simple moving average is criticised, however, due to assigning the same importance or weight to each value. In practice, in a case of a moving average of 10 periods, each value is given the same weight (on 10 periods each would count for 10%).
Weighted Moving Average
A weighted moving average (WMA) is used to clarify any issues that may not be clear with the use of the simple moving average. In this type of moving average there is more weight given to the last values in a series. All of the values in the series are added together. For example; if we have 10 values, we associate a “weight” of 1 to the first value, a “weight” of 2 to the second value and so on. These “weights” are then multiplied by the value of the data. For example; if the first has the value of 3, we would multiply this by 1, which will give it an ultimate value of 3. If the fifth period were 7, we would multiply it by 5 and so we would have the result of 35. In the end, therefore, we would add up all of the final values and divide them by the total of the “weights” used. An example with 3 periods (5,6,7) looks like this:
(5×1) + (6×2) + (7×3) / (1+2+3) otherwise written as 38/6 which equals 6.33
Even this moving average is subject to criticism due to not being able to provide an instantaneous idea of what is happening on the market.
Exponential Moving Average
The exponential moving average (EMA) is considerably more complex compared to the moving averages that we have just seen and for this reason it is used mainly by expert traders. As is the case with the weighted moving average, there is a different weight given to the various values being considered. Even in this case, more weight for the more recent values and less for the older values, but with the one difference being that many more dates are taken in consideration.
Being a moving average with a complicated calculation, it is practically impossible to generate without a computer.
In any case, to calculate the exponential moving average, there are two values to consider:
– The Arithmetic Average (as seen above)
– The Alpha Coefficient, which renders the average more responsive. To calculate Alpha we use this formula: Alpha = 2/(n+1) where “n” is the number of periods.
The exponential moving average is taken from the following:
EMA = (close – previous EMA) * Alpha + previous EMA
Comparing it to the weighted moving average. The weight coefficients are assigned with a progressive exponential value and not linear. The difference in “weight” between these values, therefore, varies exponentially.