Moving averages are used to help identify the trend of prices. By creating an average of prices, that "moves" with the addition of new data, the price action on the security being analyzed is "smoothed". In other words, by calculating the average value of a underlying security or indicator, day to day fluctuations are reduced in importance and what remains is a stronger indication of the trend of prices over the period being analyzed.
The term "Moving" refers to the method of calculation which takes the average value over a fixed period of time and adds the latest period data to the calculation of the average while dropping the first period of the calculation so that the average continues to be calculated by the same number of periods but moves with each new period of data that occurs.
Thus the average "moves" along with price and changes in value as price data is generated. An 18 day moving average represents the trend in prices over a period of 18 days. A longer 50 day moving average is smoothed more than an 18 day moving average with each new day's data making less impact on the calculation of the moving average value than a shorter term moving average such as the 18 day moving average. A longer term moving average such as the 200 day moving average is plotted to identify longer term trends in price.
A basic approach to using moving averages is to identify which term of price trend you wish to monitor and produce an appropriate period moving average. In this approach, while price is above the moving average it is an indication of bullish behavior. While prices is below the moving average it is an indication of bearish behavior in relation to the trend length being viewed. When price falls from above the moving average to below the moving average it warns that the price trend being viewed may be weakening. When price rises from below the moving average to above the moving average, it is a bullish indication of the price trend length under scrutiny. The shorter the term of a moving average, the more susceptible these signals are to whipsaws.
Since a moving average is a lagging indicator of price trend, there is a trade off between timeliness of a signal of bias change in the price trend being analyzed and the reduction of the possibility of whipsaw. A second approach is to plot two or more moving averages and look for crossover points to help identify periods of significant change in underlying bias for the tradable security. When a shorter term moving average crosses from below to above a longer period moving average it is a sign of bullish bias. When a shorter term moving average crosses from above to below a longer period moving average it is a sign that a bearish bias is present in price trend development.
There are a number of different types of moving averages that have been developed by technical analysts in the study of trends for use with price and indicators. A moving average can be arithmeticwhich is the sum of the closing prices over a certain number of time periods divided by the number of time periods to get an average price of the security for that period. An exponential moving average (EMA) is calculated by adding a percentage of yesterday's moving average to a percentage of today's closing value. In this way an investor can put more emphasis on more recent data and less weight on past data in the calculation of the moving average.
Other types of moving average calculations include time series moving average, triangular moving average, variable moving average, volume adjusted moving average and weighted moving average. In addition to the variations in calculations, investors can also shift a moving average horizontally or vertically on a graph and base the calculation on the open, close, high, low, or average price rather than the close. The most commonly used moving average is the exponential moving average based on closing prices without any shift. The value of knowing the most commonly used moving average lies in the fact that signals may influence a larger group of investors and therefore become more significant as response unfolds in the marketplace.
