What is a Moving Average?
Posted: April 2, 2015, 6:11 a.m. by atanass
Technical indicators are a bit like fashion—they go out of style as fast as they come in but some stand the test of time. The moving average is one such indicator. In all of its forms, the moving average has been the go-to technical indicator for decades but if you’re completely honest, do you really know what it is or how it works?
You remember averages from elementary school, right? You could take a list of numbers and compute the average by adding them and dividing by how many entries were on the list. An average forces you to look beyond the really good or really bad numbers and consider the overall performance—whether it is stocks, sports statistics, or health metrics.
Investors don’t much care about the average performance of a stock today—they care about it over time and since each day brings a new value into the mix, investors think of averages a bit differently. Enter the moving average.
Calculating the moving average isn’t much more difficult than that elementary school math from your earlier years. Let’s say you want to calculate the 20 day moving average of a certain stock. Simply make a list of the last 20 closing prices of the stock and divide by 20. It’s called a “moving” average because each day the oldest number is dropped, the newest is added, and everything is recalculated. Each of data point is placed on a chart with the price action of the stock and the result is the chart you’re used to seeing.
There’s also another type of moving average—the exponential. The exponential moving average assumes that you’re more interested in the price action of the stock recently than further into the past. The exponential moving average gives more weight to recent closing prices than older ones but unless you’re a math whiz, you probably don’t want to calculate it by hand. Here’s what it looks like:
Much like PCs vs. Macs, Coke vs. Pepsi, and Chipotle vs. (nothing, Chipotle is awesome), technicians argue over which to use. Most would probably say the exponential moving average but the better strategy is to examine both and see which correlates to the stock movements the best.
How Many Days Do I Want?
There’s the 10-day, 20-day, 50-day, 100-day, 200-day, and more. You can look at moving averages with any amount of days you would like but it’s most helpful to follow the heard on this decision. Start with the 50-day. Investors like the 50-day because it loosely reflects one full quarter. Next, the 20 day because it’s a calendar month, and finally the 10-day because it’s half of a month.
How Do I Use it?
Compare the moving average to the price action of the stock. The most important indicator is a crossover. When the stock’s price action moves convincingly above or below its moving average expect big things to happen. If it moves above, and stays above for a trading day or two, expect the stock to move higher. If it moves convincingly below, you might be in for some stock market pain. Remember that often, one day isn’t enough. It needs to confirm the move by staying there over a couple of days.
Second, watch for the moving average to serve as support or resistance. If the stock is moving lower and it seems to stabilize at the moving average, it has found support. That could be the end of the downward move. If it’s moving higher and but can’t break above the moving average, that’s resistance. The stock might be heading lower.
Moving averages may or may not be driving the stock at any given time. Don’t fall into the common trap of using moving averages as your go-to evaluation tool from now until the day you stop investing. Use our reports to see which screeners and woos are moving the market right now and make short-term decisions based on that.