Weighted Moving Average

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Description

A weighted moving average (WMA) is similar to a simple moving average except that the prices are weighted so that recent price data is given more weight than older price data. This reduces the lag seen in simple moving averages (which represents all price data equally), hence WMAs react more quickly to price changes.

WMAs are calculated by adding all the closing prices from a specified period multiplied by weighting factors and dividing by the sum of the weighting factors. Within the Bourse, a linear WMA is used. So, for example, a 20-day WMA gives 20 times more weight to the most recent price than to the price 20 days ago.

A linear WMA differs from an exponentially weighted moving average in that there is less contrast between the weighting of earlier and more recent prices. Though the linear WMA is more sensitive to trend changes than the simple moving average, it is less sensitive than the exponential moving average. During "flat" or "non-trending" markets the differences among the different moving averages become negligible

WMAs are lagging indicators. They are used to emphasise the direction of a trend and to smooth out price and volume fluctuations ("noise") that can confuse interpretation.

Interpretation

WMAs can be compared to the actual price. Each WMA provides a different interpretation on what the security will do. As the period decreases, the sensitivity of the WMA to price changes will increase. However, a shorter period also means that you may have a greater number of false signals.

• If the price moves above the WMA and the WMA is directed upward, it can be considered a bullish (buy) signal.

• If the price moves below the WMA and the WMA is directed downward, it can be considered a bearish (sell) signal.

Valid buy and sell signals are not given when the WMA changes direction but price does not move above or below the WMA. Another popular technique used for interpreting WMAs is to compare longer-term and shorter-term WMAs with each other.

• When a shorter-term WMA moves above a longer term WMA and both WMAs are directed upwards, it can be considered a bullish (buy) signal.

• When a shorter-term WMA moves below a longer term WMA and both WMAs are directed downwards, it can be considered a bearish (sell) signal.

Moving averages work best in trending markets. Sideways markets (with no clear upward or downward trends) tend to cause false signals. Analysts often use WMAs with other indicators to confirm price direction. Intersections between WMAs and other indicators (such as an Exponential Moving Average) can be used to pick trend changes.

Advantages and Disadvantages

Because the WMA lags the price line, its signals regarding trend changes are delayed.

A trader using a WMA is less likely to pick a trend change early but is also less likely to mistake a minor correction for a trend change. The advantage of using WMAs is that they pick up trends more quickly than simple moving averages. Some traders prefer to use WMAs for shorter time periods to capture changes quicker.

The disadvantage of WMAs is that more false signals are likely to be generated than with simple moving averages. Some investors prefer simple moving averages over long time periods to identify long-term trend changes.

TIP:

The trick is to choose appropriate periods. It is wise to test your chosen system extensively on historical data for the security in which you intend trading.

This type of moving average can also be applied to indicators. Generally, any indicator that appears as a graph below the price chart can have a moving average applied to it. Just click on the indicator graph and follow the steps above.