Moving Average

There are many variations of Moving Average (MAs) used in technical analysis. The three most common are: simple moving average, weighted moving average, and exponential moving average. The construction and use of these averages are different.

It is evident that trends in stock prices can be very volatile, almost haphazard at times. One technique for dealing with this phenomenon is the moving average (MA). An Moving Average attempts to tone down the fluctuations of any price series into a smoothed trend, so that distortions are reduced to a minimum. 

Simple Moving Average

Major Technical Principle Changes in the price trend are identified by the price crossing its Moving Average, not by a reversal in direction of the Moving Average.

A simple Moving Average is by far the most widely used. It is constructed by totaling a set of data and dividing the sum by the number of observations. The resulting number is known as the average, or mean average. In order to get the average to "move," a new item of data is added and the first item on the list subtracted. The new total is then divided by the number of observations, and the process is repeated. Generally speaking, a rising Moving Average indicates market strength and a declining one denotes weakness.

A comparison of the price index with its simple Moving Average shows that the average changes direction well after the peak or trough in the price and is therefore "late" in changing direction If it is to reflect the underlying trend correctly, the latest Moving Average should be centered, or plotted.

A time delay, though it is an irritant, is not particularly critical when analyzing other time series such as economic data. However, given the relatively rapid movement of prices in the financial markets and the consequent loss of profit potential, a delay of this nature is totally unacceptable. Technicians have found that, for the purpose of identifying trend reversals, the best results are achieved by plotting the Moving Average on the final period.

A change from a rising to a declining market is signaled when the price moves below its Moving Average. A bullish signal is triggered when the price rallies above the average. Since the use of Moving Averages gives clear-cut buy and sell signals, they help to eliminate some of the subjectivity associated with the construction and interpretation of trendlines.

More often than not, it pays to take action based on MA crossovers, pro­vided the particular time span in question has proved reliable in the past. The degree of accuracy depends substantially on the choice of MA, as dis­cussed later, as well as the volatility of the security in question. The length of the moving average will also have an influence on its accuracy. Generally speaking, the longer the time span, the more reliable the average. In effect, a moving average for any given time span on an intraday chart is likely to be much less reliable than one constructed from month-end data on a monthly chart. Now though, we need to examine some of the characteris­tics of MAs in greater detail.