Moving Averages

What is the Moving Average?

Moving average is an indicator that shows the average value of a security's price over a period of time. To find the 50 day moving average you would add up the closing prices (but not always[sigma]more later) from the past 50 days and divide them by 50. And because prices are constantly changing it means the moving average will move as well.

The most commonly used moving averages are the 20, 30, 50, 100, and 200 day averages. Each moving average provides a different interpretation on what the stock price will do. There really isn't just one "right" time frame. Moving averages with different time spans each tell a different story. The shorter the time span, the more sensitive the moving average will be to price changes. The longer the time span, the less sensitive or the more smoothed the moving average will be. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations or "noise" that can confuse interpretation.

Here is a visual example using the stock price of AT&T:

This chart was supplied by Barchart.com

Notice back in September when the stock price dropped well below its 50 day average (the green line). There has been a steady downward trend since then and no real strong divergence, until the end of December where it rose above its 50 day average and continued to rise for several weeks.

Typically when a stock price moves below its 50-100 day moving average it is a bad thing, the opposite is true for stocks that protrude their moving average.

So what do the different days mean?

The general assumption behind all moving averages is that once the stock price moves above the average that it may substantial momentum behind it and is worth buying. The opposite is true if the price of a security moves below the moving average. It's a pretty simple approach to technical analysis, perhaps the simplest of them all, but plain and simply it works, and it is the base for many other much more complicated indicators.

20 day - provides a very volatile, choppy line. It isn't the most accurate, but is probably the most useful for short term traders.

30 day - similar to 20 day but provides a bit more certainty for the trend.

50 day - moving averages provide a much less volatile, smooth line. This can be used to detect somewhat longer term trends.

100 day - similar to the 50 day, it is less volatile, and one of the most widely used for long term trends.

200 day - even less volatile, more of a rolling chart or smooth line. It doesn't react to quick movements in the stock price therefore it is rarely used.

Again, there isn't just one "right" time frame. Moving averages with different time spans each tell a different story. The shorter the time span, the more sensitive the moving average will be to price changes. The longer the time span, the less sensitive or the more smoothed the moving average will be.

Some Strategies Using Moving Averages

Different investors use moving averages for different reasons. While some use it as their primary analytic tool others simply use the moving average as confidence builder to back their investment decisions. Here are two other strategies that people use moving averages for:

Filters: Filtering is used to increase your confidence about an indicator. There are no set rules or things to look out for when filtering, just whatever makes you confident enough to invest your money. For example you might want to wait until a security crosses through its moving average and is at least 10% above the average to make sure that it is a true crossover. Remember, setting the percentile too high could result in "missing the boat" and buying the stock at its peak.

Another filter is to wait a day or two after the security crosses over, this can be used to make sure that the rise in the security isn't a fluke or unsustained. Again, the downside is if you wait too long then you could end up missing some big profits.

Crossovers: Using Crossovers isn't quite as easy as filtering. There are several different types of crossover's, but all of them involve two or more moving averages. In a double crossover you are looking for a situation where the shortest MA crosses through the longer one. This is almost always considered to be a buying signal since the longer average is somewhat of a support level for the stock price.

For extra insurance you can use a triple crossover, whereby the shortest moving average must pass through the two higher ones. This is considered to be an even stronger buying indicator.

The Different Flavors:

Of course the simple moving average that we've discussed it the most popular, but there are different modified versions of the moving average.

Exponential Moving Average (EMA) - Are calculated by applying a percentage of today's closing price to yesterday's moving average value. Use an exponential moving average to place more weight on recent prices.

Moving Average Convergence Divergence (MACD) - quite common, the "MACD" is a trend following momentum indicator that shows the relationship between two moving averages of prices. To Calculate the MACD subtract the 26-day EMA from a 12-day EMA. A 9-day dotted EMA of the MACD called the signal line is then plotted on top of the MACD. There are 3 common methods to interpret the MACD:

1. Crossovers - When the MACD falls below the signal line it is a signal to sell. Vice versa when the MACD rises above the signal line.

2. Divergence - When the security diverges from the MACD it signals the end of the current trend.

3. Overbought/Oversold - When the MACD rises dramatically (shorter moving average pulling away from longer term moving average) it is a signal the security is overbought and will soon return to normal levels.

Other less common moving averages include triangular, variable, and weighted moving average. All of them being slight deviations from the ones above and are used to detect different characteristics such as volatility, and weighting different time spans.

Conclusion

The moving average is one of the most popular and easy to use tools available for technical analyst, and wannabees for that matter. By using an average of prices, moving averages smooth a data series and make it easier to spot trends. This can be especially helpful in volatile markets, it smoothes out any noise and gives you a strong trend for the stock price.

There are several different varieties and time spans that one can use moving averages for, this is subjective depending on who you talk to. I prefer the 50 or 100 day average, but short term traders look at the 20 day average much closer. I hope this has helped shed some light on the wide range of uses for moving average and that it will help you pick better performing stocks.

Moving Averages - an Introduction:

So what do the different days mean?

Some Strategies Using Moving Averages

The Different Flavors:

Conclusion