Another function that can be used in charts for online trading is the moving average, which is widely used for the analysis of story series and especially for technical analysis. On the trading platforms (we recommend this one) you can set this type of graphic function and usually find three types: simple, exponential, and weighted.
In this lesson we will detail what these three types of moving averages are and how they differ, without going too far into technical details that you can explore personally later depending on your needs.
Simple Moving Average
The simple moving average (SMA) is also called arithmetic average and is in fact the most widely used by analysts and by those who trade online. The data of a given period is used and the average is calculated simply by adding it together and dividing the total by the number of values (e.g., 3 + 5 + 6 + 8 and divided by 4). However, the simple moving average is subject to criticism because it assigns the same importance (or weight) to each value. In practice, if we had a 10-period moving average, the same weight would be given to every single value (each of the 10 periods is 10%).
Weighted Moving Average
The weighted moving average (WMA) is used to address the previously highlighted problem with the simple moving average. Greater weight is given to the last values of a series. As for the final calculation, this remains unchanged: all the values of the same series are added together. For example, if we had 10 periods we would associate “weight” 1 to the first value, “weight” 2 to the second, and so on. These “weights” must be multiplied by the value of the data. For example, if the first period has a value of 3, we will multiply it by weight 1 and it will ultimately have a value of 3. If the fifth period is 7, we will multiply it by 5 and obtain a last value of 35. In the end, we add up the final values and divide them by the sum of the weights used. Example with three periods (5-6-7): the result will be [(5 × 1) + (6 × 2) + (7 × 3) / (1 + 2 + 3)] or 38/6 = 6.3333.
Even this is subject to criticism because it fails to instantaneously provide an idea of what is happening on the market.
Exponential Moving Average
The exponential moving average (EMA) is much more complex than the averages described above and is therefore used by more experienced users. As in the weighted average, a different weight is assigned to the various prices (or values) being considered, greater for the most recent and lesser for the oldest, with the major difference being that it takes into account much more data (e.g., many “older” values).
Being a very difficult calculation medium, it is practically impossible to generate except through the use of a computer. By the way, we can get a perfect EMA with a single mouse clic, on the trading platform.
However, to calculate the exponential moving average two values are taken into consideration:
- The arithmetic mean (seen previously)
- The Alpha coefficient, which will make the average more reactive.
To calculate Alpha, use this formula:
Alpha = 2/(n + 1) where n is the number of periods.
The exponential moving average is obtained by:
EMA (exp. M.) = (Close – previous EMA) * Alpha + previous EMA
With respect to the weighted average, the weighting coefficients are assigned with an exponential and non-linear progressive value. The difference in “weight” between the different values, therefore, varies exponentially.
Go to lesson 15 – Alligator indicator