Page 191 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 6.8.3 Moving Averages

Most chart patterns show a lot of variation in price movement. This can make it difficult for
traders to get an idea of a security's overall trend. One simple method traders use to combat this
is to apply moving averages.
A moving average is the average price of a security over a set amount of time. By plotting a
security's average price, the price movement is smoothed out. Once the day-to-day fluctuations
are removed, traders are better able to identify the true trend and increase the probability that
it will work in their favour.

Types of Moving Averages

Moving Averages may be of following types

1. Simple Moving Average (SMA): This is the most common method used to calculate the
moving average of prices. It simply takes the sum of all of the past closing prices over the
time period and divides the result by the number of prices used in the calculation.
For an instance, in a 10-day moving average, the last 10 closing prices are added together
and then divided by 10. As you can see in Figure 6.15, a trader is able to make the average
less responsive to changing prices by increasing the number of periods used in the
calculation. Increasing the number of time periods in the calculation is one of the best
ways to gauge the strength of the long-term trend and the likelihood that it will reverse.
Figure 6.15

2. Exponential Moving Average (EMA): This moving average calculation uses a smoothing
factor to place a higher weight on recent data points and is regarded as much more
efficient than the linear weighted average. Having an understanding of the calculation is
not generally required for most traders because most charting packages do the calculation
for you. The most important thing to remember about the exponential moving average is
that it is more responsive to new information relative to the simple moving average. This
responsiveness is one of the key factors of why this is the moving average of choice
among many technical traders.
(a) Linear Weighted Average: This moving average indicator is the least common out of
the three and is used to address the problem of the equal weighting. The linear
weighted moving average is calculated by taking the sum of all the closing prices
over a certain time period and multiplying them by the position of the data point
and then dividing by the sum of the number of periods.

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