Moving average forecasting can be useful for long term trades. The two types of moving averages most commonly used in swing trading and intraday trading are Simple Moving Averages (SMA) and Exponential Moving Averages (EMA). In fact, these two types of moving averages may appear similar on the chart. However, their characteristics are developed from different mathematical formulas which have different results.

It seems that every day someone will ask a question about moving averages, stop loss, profit target, or support and resistance lines in the Bullish Bears day trade chat room.

I wanted to take this opportunity to answer those questions a little more fully. Before we get into the charts, lets take a minute to fully understand the math formula behind the moving averages.

Moving average forecasting is used in all types of trade strategies. As a result, moving averages find support and resistance levels and calculate a stop percentage. They can even find a profit target during an intraday scalp, hold, and swing trade.

Hence, proper use of moving averages can offer the trader portfolio protection; by perhaps staying out of a trade. You can even protect profits; by perhaps remaining in a trade until a more profitable exit is shown.

 

http://tos.mx/l45fPx <— ThinkOrSwim Link to this Chart Example (SPX 4-Hour)

Basics

Let’s take a look at how we can use the simple moving average in moving average forecasting. In the formula for an SMA, the oldest candle of data drops away and the newest candle of data takes its place.

For example, in a 5 SMA formula using a daily chart with Daily Closing Prices (candles) of $111, $112, $113, $114, $115, $116, and $117 we can calculate the formula:

5-day SMA: (1^st day 111 + 2^nd day 112 + 3^rd day 113 + 4^th day 114 + 5^th day 115) / 5 = 113

Five-day SMA: (2^nd day 112 + 3^rd day 113 + 4^th day 114 + 5^th day 115 + 6^th day 116) / 5 = 114

5-day SMA: (3^rd day 113 + 4^th day 114 + 5^th day 115 + 6^th day 116 + 7^th day 117) / 5 = 115

These final numbers (113, 114, and 115) form the line that develops the SMA across the chart. It presents a picture of the ‘simple price average’ (or a picture of the common price) of the ticker symbol.

In this example, the 5 day ‘average’ is also the middle number being calculated. The lower numbers cause this moving average to ‘lag’ and find the middle (or find the mean or find the ‘average’).

The 5 SMA study answers this question; over the last 5 days (or the last 5 candles) what was the average price of this ticker? The SMA is also called the average, the rolling average, and the moving mean. How can you use that in moving average forecasting?

Lags

Notice that the moving average lags behind the price in this equation. On day 5 with a price of $115 the moving average is $113. On day 6, the price was $116, and the moving average is $114.

Again, on day 7 the price is $117, and the moving average is $115. This lag happens because the price needed to produce the moving average has already happened.

This indicator looks back at previous price action to calculate the moving average. This is also a lagging indicator because it takes these numbers and seeks to find the middle.

Thus a price that was further back in time then the current price action. Even as a ‘lagging average” the SMA is one of the most valued indicators in the trader’s toolbox.

 

http://tos.mx/OYtlQl <— ThinkOrSwim Link to this Chart Example (/YM DOW Futures 4-Hour)

EMA Moving Average Forecasting

Let’s take a look at how we can use the EMA for moving average forecasting. With an understanding that the Simple Moving Average lags, the Exponential Moving Average was developed as an extension of the SMA to reduce this lag.

The EMA is calculated from the whole of the previous price action. This is the first reason that the EMA is better suited for a smaller time-frame; such as an intraday chart.

Since the EMA must begin somewhere, the Simple Moving Average is calculated first. Then weights are applied to give the prices closer to the current price more consideration.

The SMA uses a math formula, which took away a number before adding a new number. The EMA keeps the whole of the previous data and adds the new price action to the rolling average with some weights applied.

The EMA weight is calculated based upon the length of the EMA chosen. The formula for a 10-day EMA would look like this:

10 SMA: 10-bar total / 10

Multiplier: (2 / (10 + 1) ) = 0.1818 (18.18%)

EMA: Close – EMA(previous bar) x multiplier + EMA(previous bar)

 

As you see in this example, the EMA uses ‘previous bar’ to begin its calculations; so the SMA is calculated first and used as ‘previous bar’. This formula is then applied to each bar between the start of the EMA to the current bar.

Just as the SMA had a weakness by lagging and by focusing on the middle of all bars calculated the EMA has a weakness in its calculations due to the amount of weight applied to each bar.

An EMA with a long length will lose weight as the calculation is applied. The 10 EMA shown above has a weight of 18.8% but an EMA of 20 only has a weight of 9.52%.

Each time the EMA length is doubled, the weight drops by half. This is the second reason that the EMA is better suited for a smaller time-frame (such as an intraday chart). Somthing to think about when moving average forecasting.

Each trader must decide what their purpose is for choosing the type of moving average and what their goal is for using the different lengths on the moving averages.

A typical setup for in intraday chart would be using the SMA as the longer length moving average (to identify support and resistance) and using the EMA as the shorter length moving average (to identify trend reversal and trade signals).

 

http://tos.mx/9LMpal <— ThinkOrSwim Link to this Chart Example (/YM DOW Futures 4-Hour)

Final Thoughts

Moving average forecasting can help you determine many important aspects of trading. In fact, the chart examples throughout demonstrate how the moving averages can offer a trader perspective on the potential price action before taking a trade.

Knowing where strong support or resistance is before entering a trade can perhaps offer the trader perspective on stop loss, target entry/exit, or to avoid taking a trade at all. Traders can protect their portfolio or protect their profits by observing how price respects these levels.