In this post we will expand into a major theme in Technical Analysis. Before e get into MACD and the likes, it’s imperative that we further explain moving averages.
Moving averages are nothing more than lines traced inside price action, that move as new prices are inserted into the graph. They are usually calculated over the closing price and can represent short, middle, or long term momentum. Who defines this are the analyst themselves, who chooses which number of historical price should be utilized to calculate the average.
At this point the question is: What average will this be? And there aren’t just one answer, but many. To calculate a moving average, many types of statistical averages may be used, the Simple Moving Average, calculated based on a simple average between the prices, and the Exponential Moving Average, calculated based on the exponential average.
Before we show how to calculate this moving average and consequently understand its interpretation, we must know that the result will be a continuous but not linear line that could be used as Support and Resistance of the prices. Since it’s a moving line, this concept of Support and Resistances using moving averages should always be followed with other analyses, since it’s very volatile and reversible.
Moving Average Formula:
Although the result for both equations might be similar, the result calculating the exponential moving average is closer to the last closing price, therefore, the EMA has a shorter response time than the Simple Moving Average, making it used more often when it comes to giving more importance to the last days of the sequence.
It doesn’t mean that one is better than the other, like with everything else in Technical Analysis, both of the graphs have better results with each of the indicators, therefore, the specific graph you’re analyzing should have both types of moving averages on it before making the conclusion of which moving average should be used.
In the images above we can see the same graph with 4 different moving averages.
The graph on the left shows two Simple Moving Averages, one is a 5 day SMA (it’s a daily chart) and a 9 day SMA. In the second image, the graph shows us a 5 day and a 9 day Exponential Moving Averages. Notice that the both exponential moving averages are closer to the closing price than the SMAs.
Notice also, that the corresponding moving average lines intersect. Sometimes the 5 day average crosses over the 9 day, and sometimes it crosses under. What does this mean? To answer this question, we have another image below, but with Simple Moving Averages of 10 and 21 days:
When moving averages of different periods cross each other, indicates a momentum. Rules of operation:
- When the shorter moving average (10 days) crosses the longer line (21 days) downwards, it’s bearish momentum.
- When the shorter moving average (10 days) crosses the longer line (21 days) upwards, it’s bullish momentum.
Notice that in the image when the lines cross for the first time, it indicates bearish momentum, however the prices keep rising instead of falling. This is common with this type of analysis, because this is a reactive signal, meaning it shows momentum based on a simple analysis of the few previous days, so if the prices move faster than the expected, then the averages are no longer valid.
To optimize this system of crossing averages, the MACD was developed, which shows the same signals here described, but also shows other precise signals and that are proactive, that show momentum in price that will happen from that specific point on.
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