There are 3 types of indicator in technical analysis-
1. Trend following indicator or laggard indicator
2. Oscillators or advanced indicator
3. Co-incidental indicators
Moving average is one of the trend following indicators. It is basically a mathematical device which is used to detect the underlying trend of the share. Moving average is popularly known as trend following indicator. It follows the trend and accordingly generates a buy and sell signal.
However, the signal we get from moving average is often a bit late. Although it produces a late signal but it is a confirm signal. Trading with the help of moving average is like attending a party where the cocktail is over but dinner is left. Hence moving average is called laggard indicator.
There are different types of moving average-
1. Exponential moving average
2. Simple moving average
3. Weighted moving average
Out of this, simple moving average is easy to calculate. Moving average is calculated with the help of closing price. If we want to find out the ten day moving average of a particular share, we will consider last 10 closing prices, add them and then divide it by 10, whatever the result produced will be known as 10 DMA.
With the passage of time, as more and more research came into the subject, the system of double moving average was brought in. In this system, we will have two different periods and thereby two individual moving average. Whenever we choose any time frame either 7,20 or 5,10 or 9, 15, we normally have two period out of which one is smaller period and the other is a longer period. The smaller period is called short term moving average (STMA) or present MA and the long term is called LTMA or past MA.
The relative relation between these two line of moving average gives us a proper signal with regards to the direction of the trend. The most commonly used combination is 13 and 30. We must note that this 13 and 30 is used on a weekly chart top understand proper direction of the price. Weekly chart means we have to consider the last working day closing of the week for 13 and 30 as well. The system of DMA works as follows-
a. During an uptrend, the 13 weeks moving average (STMA) will be greater than 30 weeks (LTMA) and both constantly rise as long as these 2 averages behave in the manner, we have to say that trend is definitely up.
b. During a downtrend, the 13 weeks MA (STMA) will be lesser than LTMA of 30 weeks and both will continue to fall. As long as this behavior is on, the trend is perfectly down.
We must note that we are either interested in both the line rising or both the line falling. Apart from these, any other line behavior, we are not interested. For example, sometimes it happens that short term moving average is rising whereas the long term is falling. This is not a perfect signal of any trend because both the line are in opposite direction. Hence apart from straight rising or straight falling, any other line behavior is not to be taken into consideration.
According to the time, trends are divided into three different sections-
1. Short term trends
The duration of the trend lasts for o days to 3 weeks. We can use 20 DMA or a combination of 4, 9 and 18 DMA.
2. Intermediate trend
This trend lasts for a period of 3 weeks to 3 months. Some people call it secondary trend. We can use the combination of 13, 30 weeks SMA.
3. Long term trend
Any trend that lasts for a period of 6 months or above, this is called long term trend., To understand the direction of long term trend, we can use 50 and 200 MA (days).
In order to understand the short term trade, we have to use 3 moving averages i.e. 4 DMA, 9 DMA and 18 DMA. During an uptrend for short term, 4 DMA will be greater than 9 DMA and 9 DMA will be greater than 18 DMA. For a short term down trend, 4 DMA will be less than 9 DMA and 9 DMA will be less than 18 DMA. Needless to say, during an uptrend, all the 3 will rise and during a downtrend, all the 3 will fall. The same logic can be applied for intermediate and long term trend.