How to use Moving Averages in Financial Spread Betting

Simple Moving Averages (SMA)

Moving average lines are one of the simplest indicators to use and understand. They are also very straightforward to calculate although a trader never actually has to do this.  The table below shows how a 5 period simple moving average (SMA) and a 10 period simple moving average are calculated.

Column A displays the price at each point in time. Column B is the cumulative total of the previous periods’ prices – so on line 5 the total of 64 comes from adding the prices for periods 1 to 5; on line 6 the total of 69 comes from adding periods 2 to 6 and so on. The 5 Period SMA in column C comes from dividing the cumulative total by 5. This needs 5 periods of data to calculate which is why the SMA in periods 1 – 4 is blank in the example.

The 10 period SMA in column E is calculated similarly except it adds up the previous 10 periods of data and divided by 10.

The SMA numbers are then plotted on the price chart and joined to produce a simple moving average line as shown in the Figure 1.

Simple Moving Average Calculations - Example

	A	B	C	D	E
Period	Price (p)	5 Period Cumulative Total	5 Period SMA	10 Period Cumulative Total	10 Period SMA
1	10	10		10
2	13	23		23
3	14	37		37
4	13	50		50
5	14	64	12.8	64
6	15	69	13.8	79
7	16	72	14.4	95
8	17	75	15	112
9	19	81	16.2	131
10	22	89	17.8	153	15.3
11	24	98	19.6	167	16.7
12	26	108	21.6	180	18
13	23	114	22.8	189	18.9
14	21	116	23.2	197	19.7
15	19	113	22.6	202	20.2
16	17	106	21.2	204	20.4
17	14	94	18.8	202	20.2
18	13	84	16.8	198	19.8

 

Figure 1.

The moving averages are designed to show the general movements of prices over a period of time. The longer the moving average the more ‘general’ or smoothed this becomes. You will note from the chart that the shorter moving average, the 5 SMA, hugs the data much more closely than the 10 SMA. As the moving average period lengthens the smoother the SMA line becomes.

Exponential Moving Averages (EMA)

Another type of moving average used in charts is the exponential moving average (EMA). Whilst mathematically slightly more complex it does a similar job to the SMA except that it weights the more recent prices heavier than the older ones thereby giving slightly more emphasis to the latest movements. There is no critical reason to use the EMA or the SMA as they give broadly similar results.

What Moving Average Period to Choose?

There is no right or wrong period to choose for a moving average but traders will tend to superimpose two or three moving average lines on to a chart. These will be to highlight a short term moving average, a medium term, and (no surprise) a longer term one. So for instance there may be three lines – an 8 SMA, a 21 SMA and a 200SMA. The very long, 200 day average, will be used to determine the general sentiment regarding price on an instrument whilst the shorter moving averages will act as a guide as to the more immediate price movements.

Cross over points become important when multiple moving averages are used on a chart. A shorter moving average crossing a longer one from below would be an indication of stronger buying for an instrument and vice-versa.

Figure 2 below shows the example introduced in the charts section of HSBC. This time we are looking at weekly candles over a one year period and have introduced three moving averages over the graph. A short (8 period simple moving average), a medium (21 period simple moving average) and a long (200 period simple moving average). Two main things might be deduced from this snapshot. Firstly, the longest average indicates that the long term trend is downwards. Secondly, where the 8 week sma crossed the 21 week from above it signified a further downturn in the share price through until July 2010.

Figure 2.

Moving Averages are Lagging Indicators

Moving averages are a reflection of previous price movements and are therefore known as lagging indicators. This is very well demonstrated by the chart in Figure 1 where, whilst the 5 period SMA curve has virtually the same shape as the actual price movement, it is slightly out of phase – i.e. it is positioned to the right of the actual prices. This highlights the fact that the SMA curve won’t tell you what is happening, it will tell you what has happened.