We are familiar with the concept of averages. Moving averages is the extended version of simple averages. Traders use moving averages as it is simple to calculate & understand. Therefore, it is also called a simple moving average.

Let's understand the calculation of a simple average. Let's assume that a group of 5 friends went to eat ice cream in an ice cream parlor.

The total number of scoops consumed = 4+3+5+2+1 =15

The average number of scoops consumed by each person = 15/5=3

A & C have consumed more than an average number of scoops, whereas D & E have consumed less than an average number of scoops.

The same concept is used in the case of stocks. Let us take the example of TCS. The closing price of TCS for the last five days is provided (7^th & 8^th August are holidays being Saturday & Sunday)

The average closing price will be = 3200+3300+3320+3334+3344/5=3299.6. On 12^th August, the new price record will be added. For calculating the moving average of the last five days, you will have to consider the closing prices of the 6^th,9^th,10^th, 11^th & 12^th August.
The sequence keeps moving a day ahead & therefore, it is called a moving average.

In technical analysis, moving averages are calculated based using open, high & low prices as well. But, the traders use closing price averages as it gives the final price for the day.

As we will move ahead with the latest data closing prices, the moving average will change. This is called Simple Moving Average SMA & we have used the data of 5 days; therefore, it is called a five-day SMA.

Weighted Moving Average (WMA)

The WMA is calculated by multiplying the price with associated weights.

WMA = (3200*1/15) + (3300*2/15) + (3320*3/15) + (3334*4/15) + (3344*5/15)

          = 3321.07

Exponential Moving Average(EMA)

In SMA, we have given equal importance or weightage to each day's data. But we have to allot more weightage to the latest data, the latest closing price. This is because the latest closing price would have discounted itself after considering the latest news in the market. The difference between weighted moving average & EMA is that in EMA, the decrease in the weightage given to the two prices is not the same.

Compared to SMA, EMA reacts quicker to the current price as it gives more importance to the latest closing price.

The calculation of EMA is complicated as compared to SMA. We will learn it in upcoming modules. But, most of the technical analysis tools provide EMAs with just a drag & drop of EMA on prices.

Now let's see the application of moving averages

The moving average is used to set up a trade. If the stock price is below its average price, it indicates that sellers are willing to sell the shares at a price below the average price, meaning the market can give selling opportunities. The traders are expecting a downtrend.

If the stock price is above its average price, it indicates that buyers are willing to buy the shares above the average price, meaning the market can give buying opportunities. This is because the traders are expecting an uptrend.