For a long time, simple moving average was considered the norm when it came to technical analysis in any field, including financial markets; however, several drawbacks have prompted the research and development of another technique, weighted moving average. This is especially true when it comes to exponential moving average, itself a highly specialized form of weighted moving average.
Why do we need weighted average in the first place?
The reason is simple: the previous model, simple moving average, only accounted for arithmetic average of closing prices over a number of time periods – usually days. By comparing simple moving averages, you could theoretically hazard a guess as to the direction and strength of a financial trend, while effectively nullifying any fluctuations that might throw you off. However, to most people, this would not even qualify as an educated guess, since the first and the last entry (as well as all entries in between) are treated equally. This would not be an issue if the goal was to analyze data statistically and preserve it for posterity; however, the goal is to use previous experience to guess future events, and this requires a different mathematical formula.
How does weighted moving average work?
The main difference between simple moving average and weighted moving average is the fact that the latter is biased toward certain entries and the former is not. Otherwise, the principle is the same: you add all entry values and divide the sum by the number of entries to get the average. However, weighted moving average usually involves a number of points (or percentages) which are added to entries based on how recent they are: the latest entry gets the biggest boost, the one before it gets a slightly smaller boost and so on. The oldest entry gets the smallest boost or none at all. Needless to say, simple moving average and weighted moving average of the same set of data need not necessarily show the same tendency, let alone the same result. As to which one is right, only time will tell.
How does one calculate moving averages?
The answer is simple: One does not. Most platforms will do it automatically for you, by displaying all kinds of charts, which unfortunately you need to learn to decipher. You will probably get to switch between simple, weighted and exponential moving averages at will, and base your trade decisions accordingly. Generally speaking, any one of them can be wrong, but all three… If they all agree on a general trend, it is usually a good sign, meaning this is a trend you can count on – theoretically. Usually just the simple and exponential moving average will suffice, as those are the most reliable ones available.
As for weighted moving averages, they are popular because they allow traders some freedom when assigning criteria for their own private analysis. Their versatility means you can make any kind of calculations and assign points. Usually, traders go for a variation called EMA.
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