Moving Averages

Starting out in financial markets can leave a lot to learn, but moving averages are one of the first methods of assessment new traders pick up, because of the relative simplicity of the system.

When it comes to trading, being able to identify a trend is a major asset. Once you can work out whether the market is slowly going up or down, albeit in a rather bumpy fashion, you can start to calculate where you expect it to move next. Whilst it may seem obvious, spotting an overall trend can be incredibly difficult when it is being disguised by many smaller peaks and troughs along the way.

One of the most popular technical analysis tool consists of moving averages. These are very simple to draw and test; in fact moving averages form the building block for many of the trend following trading systems in use today.

Following the Trend

Moving averages are a good way to highlight a given trend as well as identify when a change in direction occurs. They perform particularly well in a market that is trending strongly but not so well when trade is moving sideways. That’s why it’s essential to have other tools to rely on when moving averages aren’t making much sense or are failing to point in any particular direction.

In a nutshell, the moving average is simply the average price of a stock or market over a specified period of time. Its calculation is simple; add the closing prices for the period in question and divide by the number of trading days. For example, the five-day moving average would tot up the closing prices for the previous five days and then divide by five.

This is known as the simple moving average (SMA) as every day within the period carries the same amount of weight. There are other versions of the moving average that give weight to some of the data. However, most investors will learn everything they need to know from the SMA.

The problem with chart patterns is that they are often difficult to analyse and it is quite difficult for a software application to plot chart patterns since this area can be so subjective. However, it is relatively simple for a charting software application to draw averages because a moving average is simple the average of certain data. In fact, I’ve personally seen ‘black box’ trading systems sold for many hundreds (if not thousands!) of dollars that I’m sure were simply based on moving averages.

Short, Medium or Long – the Choice is Yours

It is possible to change the timeline depending on how you are trying to trade; longer term traders would be more interested in the general movement whilst scalpers are concerned with the minute-by-minute adjustments. Traders considering fairly short term positions would usually use a 5-13 day moving average. Those with a medium term plan look at 50-100 day moving averages and those in it for the long haul usually stick with moving averages of more than 100 days, most often the 200-day chart.

Many traders use a combination of short and longer term moving averages to help identify trends and direction. This is because a moving average is exactly what it says – a moving piece of data. As the next period expires, it is added to the chart and the oldest piece of data drops off.

This helps to provide a smoothing effect to the result and minimise the distracting day-to-day minor fluctuations that can mask the true trend or movement. This effect is most pronounced in longer term moving averages than those in the short term.

Moving averages are a tool that even seasoned investors opt to include because despite their simplicity, they are a good way of tracking where the market has been. It also shows its overall direction and by comparing the current closing price to the average, it is possible to get an idea of where things may be heading.

Ways of Using Moving Averages

If you ask 2 or 3 chartists to analyse a chart pattern, they may come out with 2 or 3 different opinions. One may see a trend line being broken, while another may recognise an ascending triangle and one may simply not see much going on. Moving averages on the other hand provide factual information.

The most common moving average is based on a 10-day timeframe, however you can use any timeframe you want – 10 days, 40 days, 100 days..etc Let’s take the case of a 10 day moving average. You would simply take the last 10 days of closing prices for a market instrument and add them together and then divide by 10. On the 11th day you would add that day and drop off the first day so that the last 10 days of trading continue to be used for the calculation.

Of course there are other ways to use moving averages, like using a short term average and a long term average and plot them using two separate lines. This system would consist of a trend following setup whose scope is to notify the technical analyst that the original trend has come to an end or that a new trend is starting to form. This also means that such a system lags the price action (as opposed to being a leading indicator). Thus, in a way it serves to highlight what has happened in the past and by itself doesn’t help to tell you what the future may hold.

Note that short term averages will always stick closer to the current price action more than a longer term average such as a 30 or 40 day average will. While most investors use closing prices for the computation of moving average it is also possible to use other points such a mid-point value which amounts to the price that is halfway between the high and the low of the day’s range.

Moving averages are discussed in more detail here.

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