Moving averages indicators tend to be one of the more popular and uncomplicated tools that are utilized by technical analysts. By averaging price series, moving averages smooth a data series, thereby allowing to spot trends easily. This is often useful in highly volatile and unstable markets by filtering out some of the noise in the market.
In a simple moving average, each one of the findings and observations used to calculate the average value is weighted equally. Many times, it may be appropriate to put a lot of weight on the findings which are closer to the timeframe being averaged. An example of this would be if the analyst wanted to decrease the lag. When this procedure is followed, it is known as a weighted moving average method.
Basic Equation – Sum of the Weights in a weighted moving average method must be equal to 1.
Where:- W1, W2, W3, W4…...Wn - Weight factors for each day in the n day moving average.
Example: Under- mentioned is the demand for cotton in the factory project for each month
The factory manager was asked to forecast the demand of cotton for the 10th month using 3 period moving average techniques.
Given – use weighting scheme of 0.4, 0.3, and 0.2
With reference to the above details, the factory officer quickly calculated the weighted moving average method for the 10th month as follows.
Weighted moving average (3): F11 = 0.4(132) + 0.3(126) + 0.2(121) = 52.8 + 37.8 + 24.2 = 114.8
In the chart below you will see two different types of moving averages. In red you have the weighted moving average and in blue you have the simple moving average. See how the price always crosses the red line first; it is closer to the market. Also notice that the red line also gets hit with market noise more often.
Weighted moving average - Advantages
Since the WMA technique pays more attention to price values, it is considered more sensitive to price activity compared to the usual technique of Simple moving average. This means that WMA will have far less lag then an SMA. This benefit will allow the investor to pick developments and trend changes faster compared to Simple moving average.
Weighted moving average – Disadvantages
The actual drawback associated with weighted moving average method is that, more false signals are likely to be produced as compared to Simple moving average method. This is due to the fact that it is closer to the market movement.