Moving averages are popular, reliable, and one of the simplest trend indicators in price charts. These are closing prices for a given number of consecutive trading days. The averages can be for the short-, intermediate- or long-term, based on what the investors want.
While short term moving averages are closer to and impacted by daily price changes, the long-term moving averages are smoother and indicate a clear direction of the price movement. Though one must keep in mind that these trends are indicative of historical prices.
A 7-day moving average (MA) is a short term trend indicator. It is quite simply the average of closing prices of the last seven trading days. On the price chart, it is a trend line that tells you how the average closing prices moved over a week.
Price chart of a 7-day MA of the BSE Sensex
The purple trend line represents the 7-day trend of the stock price of BSE Sensex. It reflects the steep downward trend in prices due to specific global triggers like the Coronavirus pandemic, spiralling economy as an impact of the epidemic and large scale dumping of stocks by sellers in an attempt to get out of the investment before making more losses.
How is it Calculated?
Adding up the closing prices of a stock for a given number of days represented by n (day 1+day2+day 3…day n) and dividing the sum by n will provide you with the moving average for the given duration.
Let us take a hypothetical example of stock ABC with its closing prices for the last seven trading days given below:
|Day||Closing price (Cp)|
7-Day moving average=(Cp1+Cp2+Cp3+Cp4+Cp5+Cp6+Cp7)/7=416.
To calculate the average for day 1, the 7-day moving average will average out the prices for the last seven days. In calculating for day 2, we will remove the first data point and add the value for the 8th day, to continue with the calculation of the moving average. This helps to keep the moving average in tandem with market movement.
Closer to Real Prices: Short Term Moving Averages Have Lesser Lag
A common criticism against moving averages, particularly longer-term moving averages is that they come with a lag effect since they deal with prices of the past. A short-term moving average shows the direction where the markets have already reacted to price changes. But even so, moving averages have great utility for traders to get a glimpse of future trends and if prices have bottomed-out or peaked. It can indicate opportunities on the chart, to enter and exit trades and make profits from these trades. Short-term moving averages appear particularly more reactive to price changes.
Acts as Support-Resistance
An essential application of the moving averages is it can double up as support and resistance levels in the near term. Traders can decide when to enter a trade and when to exit a position based on these levels because prices usually touch the points of support and resistance lying on the moving average before retreating from these levels.
In another popular trading strategy, traders use moving average to decide when to buy or sell. According to this strategy, they buy when prices are above the moving average and sell when it is below the moving average. Traders also simultaneously look at the rise and fall of the trading volume. That is, if the price is rising along with an increase in volume, that reflects demand potential, and makes it a more effective decision to buy.
Finally, moving averages at their simplest are trend indicators and very useful in trending markets. It quickly shows you if stock prices are following an upward trend or downtrend. A steep, trend line it may signal peaking of prices. On the other hand, a steep downward movement may be signs of a bottoming-out of prices.
Traders use multiple moving averages of varying durations to arrive at potential uptrend or downtrend in the near future. If a short-term moving average is above the long-term one, then traders can expect a similar upward trend in prices. When the short-term MA is moving below the longer-term MA, it may signal a downtrend soon.