The weighted moving average (WMA) is a popular indicator for the stock market’s technical analysis. It helps traders determine trends in security prices and also identify trend reversals, which are extremely important to make trading decisions.
The weighted moving average is a kind of moving average that assigns a higher weight to recent observations than to older observations. As it assigns more weight to recent observations, it is more responsive to the changes in recent observations than the simple moving average (SMA).
WMA can help traders decide when to buy or sell a security. For example, if a security’s price inches closer to its WMA or moves above it, it could mean that the price rise is not sustainable and hence it is a good time to sell it.
On the other hand, if a security’s price falls to reach the level of its weighted moving average or declines even lower, it could mean that it is a good time to buy it.
That said, you should never decide to buy or sell a security based solely on its WMA because over-relying on one indicator can be risky. Hence, you should use WMA in combination with other indicators.
What is the Weighted Moving Average (WMA)?
The weighted moving average is a famous type of moving average that is used to smooth out price data and identify trends. Typically, stock prices move a lot from day to day. Hence, there tends to be a lot of noise in their movements, which makes it difficult to interpret them. So, traders use WMA, which is calculated by giving more weight to recent prices than to older prices. To calculate a security's WMA, we assign a weight to each of its price points in a period. Based on this analysis, we can gauge the direction a stock's price is likely to take. WMA reacts faster to price fluctuations than SMA, which makes it a better market in highly fluctuating markets.
How to Calculate Weighted Moving Average?
While calculating the weighted moving average (WMA), we assign more weight to recent price points than to older price points. However, we need to ensure that the sum of all weights assigned must equal 100% or 1. The higher the weight, the higher the importance of that price point.
We need to follow these steps to calculate the weighted moving average:
a) Identify the data set: The first step is to identify the data set to calculate WMA. Let us say that we want to find out the weighted moving average of a stock’s price between August 1 and August 5. Assume that the stock traded at these prices ₹100, ₹110, ₹105, ₹103, and ₹107 on August 1, August 2, August 3, August 4, and August 5, respectively.
b) Assign weights to prices: In the second step, we have to assign weights to prices. Remember that weights are assigned linearly to calculate the weighted moving average. Let us say that we assign these weights 1, 2, 3, 4, & 5 to prices on August 1, August 2, August 3, August 4, and August 5, respectively. If we add 1, 2, 3, 4, and 5, we will arrive at 15. The following table shows how weights will be assigned to prices.
Date
| Closing Price
| Weightage
|
August 1
| 100
| 1/15 = 0.067
|
August 2
| 110
| 2/15 = 0.133
|
August 3
| 105
| 3/15 = 0.2
|
August 4
| 103
| 4/15 = 0.267
|
August 5
| 107
| 5/15 = 0.333
|
c) Multiply each price by its weight: Now, we need to multiply each price observation with its weightage, which is done in the table below:
Date
| Closing Price
| Weightage
| Price * Weightage
|
August 1
| 100
| 0.067
| 6.7
|
August 2
| 110
| 0.133
| 14.63
|
August 3
| 105
| 0.2
| 21
|
August 4
| 103
| 0.267
| 27.501
|
August 5
| 107
| 0.333
| 35.631
|
d) Sum up all the prices multiplied by their respective weight: Now, we need to add all the prices that are multiplied by their respective weight to calculate the WMA as shown below
Weighted Moving Average = 6.7 + 14.63 + 21 + 27.501 + 35.631 = 105.462
WMA vs. Simple and Exponential Moving Averages
It is extremely important to know the differences between the weighted moving average (WMA), the simple moving average, and the exponential moving average (EMA) for all kinds of traders. So, please refer to the table below:
Criteria
| Weighted Moving Average (WMA)
| Simple Moving Average (SMA)
| Exponential Moving Average (EMA)
|
How is it calculated?
| We multiply each price point with a weight. Recent observations are assigned a higher weight than older observations.
| We calculate a simple average of all the price observations over a period.
| We assign exponential weights to prices. We assign higher weights to recent prices than to older prices.
|
How does it respond to price fluctuations?
| WMA is more responsive to recent price changes than SMA because it assigns more weight to recent price points.
| Because all prices are assigned an equal weight, SMA is less responsive to recent price changes.
| As exponential weighting is used, EMA is the most responsive moving average to recent price changes.
|
When is it used?
| It is more suitable for short term trend identification than SMA.
| It is suited for long term trend identification.
| This is the moving average to identify trends in the short term because it is the most responsive to recent price changes.
|
How difficult is it to calculate?
| WMA is more difficult to calculate than SMA because it requires assigning weights to price points.
| SMA is the simplest moving average to calculate. All we need to do is add the price points and divide that by the number of observations.
| Because exponential weights are used in this case, EMA is the most difficult moving average to calculate.
|
Conclusion: Enhancing Analysis with WMA
There is no denying that the weighted moving average (WMA) is a useful indicator for all kinds of traders. However, traders should learn when to use it. For example, if prices are somewhat stable and you need a long-term direction, then SMA is a better indicator than WMA. WMA is a better indicator when recent prices fluctuate a lot. Besides, you should use WMA in conjunction with other indicators because it can give you misleading signs when used alone.