fbpx
weighted moving average (WMA)

What is a Weighted Moving Average?

Want to know more about investing and trading? You can learn the basics of weighted moving average among others. Learn more about weighted moving averages.

The direction of the trend is identified by a weighted moving average that is a technical indicator. It creates a trading signal by giving more weight to recent data points and less weight to historical data points.

Introduce

A technical indicator is a weighted moving average (WMA) that weights more recent data points and less weights older data points.

The numbers in the data set are individually multiplied by a predefined weight before being added together to obtain the WMA.

  • Traders use a weighted moving average to provide trading signals that tell them when to buy or sell a stock.

What is a weighted moving average?

The technical indicator that traders use to determine the direction of a trade and whether to buy or sell is the Weighted Moving Average (WMA). Recent data points are given more weight and historical data points are given less weight. Each observation in the data collection is multiplied by a predefined weight to obtain a weighted moving average.

Traders who generate trading signals use the weighted average tool. For example, a signal could be a signal to close a trade when price movement is towards or above a weighted moving average. However, if the price movement approaches or falls just below the weighted moving average, it may indicate that it is time to trade.

Using a weighted moving average is more accurate than the default moving average, which weights all values ​​in the data set equally.

How to calculate a weighted moving average?

When calculating a weighted moving average, recent data points are given more weight and historical data points are given less weight. It is used when the figures in the data set have varying weights relative to each other. The combined weight must be equal to 1 or 100% of the total.

It differs from a simple moving average in that each value is weighted equally. Compared to a simple moving average, the final weighted average value captures concurrency frequencies better because it takes into account the importance of each data point.

Example 1

We need a weighted moving average of the values ​​of four stocks: $66, $68, $69, and $70, with the first price being the most recent one. Assume there are 10 periods.

Based on the data provided, the most recent period will have a weight of 4/10, the previous period will have a weight of 3/10, subsequent periods will have a weight of 2/10, and the first period will have a weight of 1/10.

The calculation is done using the formula below the weighted average for 4 different prices.

WMA = [70 x (4/10)] + [66 x (3/10)] + [68 x (2/10)] + [69 x (1/10)]

WMA = $28 + $19.80 + $13.60 + $6.90 = $68.30

Weighted Moving Average Formula

The weighted moving average formula is written as:

where: N is the time frame.

How does a weighted moving average work?

Now that we understand how to determine the weighted moving average of a given set of values, let’s see how to utilize this indicator in our trading.

When the price is above the weighted MA line, it usually indicates that the asset is trading above its average during the review period. It also supports an uptrend. Alternatively, a downtrend is confirmed when the price is below the WMA line.

A rising weight MA can be used to highlight areas of support and resistance for price action. At the same time, a decline in WMA can indicate price action resistance over a period of time. A trader places a buy order when the price is close to the rising weight MA, and uses a sell order when the price is close to the falling weight MA.

Price activity above the moving average is used to confirm price strength and market momentum. The most recent price is now higher than the average, indicating that the market is getting stronger than before. On the other hand, if the price moves below the moving average, it indicates that the market is weakening from its previous level.

To measure price changes – a weighted moving average is a good indicator. They are usually more sensitive to price movements, so they can spot trends faster than a simple moving average. The WMA is a potential drawback as it is more likely to experience volatility than the matched SMA.

WMA can be used in conjunction with other technical indicators such as the Keltner Channel to identify the best trading signals. Traders can join the market close to the WMA when the price falls from the highs of the Keltner channel and the market is bullish.

Weighted Moving Average Trading Strategy

1. Triple Moving Average Crossover Strategy

triple MA strategy
image source: mql5

The triple moving average approach draws three separate moving averages to generate buy and sell signals. Compared to the double moving average crossing technique, this moving average strategy can better deal with false trading signals. A trader can determine whether the market has truly experienced a change in trend or paused before returning to its previous state by comparing three moving averages with different transition periods. A buy signal is generated early in the trend development and a sell signal is generated early in the trend breakout.

The signals they generate are confirmed or disproved using a third moving average along with the other two moving averages. As a result, traders are less likely to act on misleading signals.

Moving averages follow the price curve more closely the shorter the duration. Fast moving averages (short-term) will start rising much earlier than slow moving averages when security enters an uptrend (long-term). Assume that the security has increased in value by the same amount each day during the previous 60 trading days before starting to decline over the next 60 days. The 20-day moving average and the 30-day moving average will begin to decline on the 11th and 16th trading days respectively, and the 10-day moving average will begin to decline from the 6th trading day.

The length of time the trend lasted affects the likelihood that the trend will continue. For this reason, if you start a trade too early, you may have to leave a position with a loss after entering the wrong signal, and if you wait too long to enter a trade, you may miss a large portion of your profit. Trading strategies such as triple moving average crossovers try to ride the trend for the correct amount of time while avoiding false signals to deal with this problem.

To illustrate this moving average method, we use the 10-day, 20-day and 30-day simple moving averages shown in the chart below.

Different moving averages should be used for different time periods depending on the time period the trader wants to trade. Due to their tendency to closely track the price curve, exponential moving averages are preferred for shorter time frames (over 1-hour bars) (eg 4, 9, 18 EMA or 10, 25, 50 EMA). Traders prefer moving averages for longer periods (daily or weekly bars) (e.g. 5, 10, 20 SMA or 4, 10, 50 SMA). The duration of the moving average depends on the skill of the trader and the securities being traded.

Consider where the three moving averages reverse direction at point “A” in the chart above. The purple line represents the slow moving average, the green line represents the medium moving average, and the red line represents the fast moving average (10-day SMA) (30-day SMA). There is a sell signal when the fast moving average crosses below the intermediate and slow moving averages. The average price of the last 10 days has fallen below the average price of the last 20 and 30 days, indicating a short-term change in the trend.

A sell signal is indicated when the intermediate moving average crosses below the slow moving average. Momentum change is judged to be more severe when the middle moving average (20-day) breaks below the gentle moving average (30-day).

A triple moving average crossover technique provides a sell signal when the slow moving average is higher than the middle moving average and the middle moving average is higher than the fast moving average. The system is out of position when the fast moving average crosses the intermediate moving average . Because of this, triple moving average trading systems are less common than double moving average trading systems. If the slow moving average and the middle moving average do not match the relationship between the middle moving average and the fast moving average, the product is no longer available.

Rather than waiting for a trend to be confirmed, aggressive traders take positions based on a fast moving average that crosses a slow moving average and a medium moving average. You can also enter locations at various points. For example, a trader would take a certain number of long positions when the fast MA crosses above the medium MA, another set of long positions when the fast MA crosses the slow MA, and then take a long position when the medium crosses the slow MA. can be added. Mom. If a trend reversal is seen, he can resign his position at any time.

2. Moving Average Ribbon

moving average ribbon
image source: investopedia

The moving average ribbon is an advanced variant of the moving average crossover technique. This moving average approach is created by superimposing a number of moving averages on the same chart (the chart below uses 8 simple moving averages). When choosing the length and type of moving average, you should consider the time span and investment goals. A strong trend is one in which all moving averages move in the same direction. Similar to how triple moving average crossover systems generate trading signals, traders must select the number of crossovers needed to initiate a buy or sell signal.

When the fast moving average crosses the slow moving average, traders look for buys and vice versa.

3. Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD)
source image: InCountryValueOman.net

The Anchor Moving Average Convergence Divergence or MACD is a momentum trend indicator. It consists of three time series combined and created as moving averages using historical price data, most frequently closing prices. The difference is represented by the MACD line between the closing price of the fast (short-term) exponential moving average of a particular security and the slow (long-term) exponential moving average. The exponential moving average of the MACD line acts as a signal line. Traders look for a cross between the MACD and the signal line while using this moving average approach.

The three elements that make up the MACD strategy are denoted by the letters MACD(a,b,c), where the MACD family is the difference between EMAs with periods “a” and “b”. The EMA of the MACD series, which acts as a signal line, has a period of “c”. The most popular MACD technique uses 9-day EMAs for signal series, denoted MACD, and uses 12- and 26-day EMAs for MACD series (12, 26, 9). The chart below was generated based on these input parameters.

The MACD line is created by subtracting the 26-day EMA of the closing price from the 12-day EMA. Signal line = 9 days MACD line EMA MACD line + signal line is like a histogram.

The daily closing price (blue line), 12-day EMA (red line), and 26-day EMA are all displayed at the top of the chart (green line). The MACD series (blue line), signal series (red line), and MACD histogram (black vertical line) are all displayed respectively in the lower half of the chart. The MACD series is calculated by subtracting the fast-moving average (12-day EMA) from the slow-moving average (26-day EMA), and the signal series by taking the fast-moving average by taking the 9-day EMA. .

The MACD chart can be interpreted in a number of ways. The MACD line across the signal line is the most used signal trigger. It is recommended to buy underlying securities when the MACD line crosses above the signal line and sell when the MACD line crosses below the signal line. These occurrences are interpreted as indicators that the trend in the underlying security is set to strengthen in the cross direction. A zero crossover is another crossover that traders consider. This happens when the slow and fast moving averages of the price curve intersect, or when the MACD series reverses its sign.

A bearish signal is a positive to negative signal, and a bullish signal is a negative to positive signal. A zero crossover confirms a trend change, but is less reliable than a signal crossover in generating a signal. The ability of the histogram to show the divergence between the MACD line and the signal line is another indicator that traders pay attention to. As the histogram begins to decrease, the trend weakens (going to the zero line). This happens when the MACD and signal lines converge.

However, a rising histogram (away from the zero line) or diverging signal and MACD lines are signs that the trend is increasing.

MACD, like other moving average algorithms used to predict trends, can produce false signals. A false positive occurs when a bullish or bearish crossover is followed by a sharp decrease or increase in underlying security, respectively. Stocks quickly accelerate up or down when there is no crossover yet. It is a false negation.

Weighted Moving Average vs Simple Moving Average

The two most widely used statistics in the world for determining the average of observations in data collection are the simple moving average and the weighted moving average.

A simple moving average estimates the mean by adding up all observations in a data set and dividing the result by the total sample size. This is the main difference between the two statistical measures. Simply put, each observation in the sample is weighted equally positively.

A weighted moving average applies a specified weight or frequency to each observation, whereas the most recent observations are given greater weight than observations in the distant past to compute the average.

Conclusion

It is important for traders to understand how to combine weighted moving averages with other technical indicators. That said, moving averages aren’t inherently superior to others because they only use different techniques to calculate average prices. So, the optimal MA type will ultimately depend on how you trade. Also consider making significant modifications to the settings for each market. You can see that the 50-period WMA works well in one discipline but not in another. To get the best results in your trading, you need to understand how to use and interpret WMA like any other product.