The term “moving averages” is widely employed within the realm of financial analysis, and almost everyone has a basic comprehension of what they are and how they are used. Yet few truly understand the intricacies of moving averages and the many ways they can be used to maximize trading profits in the financial markets.
A growing interest among the investing public about moving averages has spawned a number of books on the subject in recent years, yet few books, despite theirmerit, really come close to providing the essence of what moving averages are, and how and when they should be used. To that end, we have written this article with the hope that it will go far in aiding the serious trader or investor about the proper way of incorporating moving averages into his or her market analysis.
A moving average is an indicator that shows the average value of a security’s price over a period of time. When calculating a moving average, a mathematical analysis of the security’s average value over a predetermined time period is made. As the security’s price changes, its average price moves up or down.
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The five most commonly used types of moving averages are the simple, or arithmetic; the exponential; the triangular; the variable; and the weighted moving average. Moving averages can be calculated on any data series, including a security’s open, high, low, close, volume, or other indicator.
A moving average of another moving average is also commonly used in various forms of technical analysis. This technique is used for purposes of tracking the price momentum of a stock or commodity and is constructed by averaging the moving average of the price being followed.
The only significant difference between the various types of moving averages is the weight assigned to the most recent price data. Simple moving averages apply equal weight to the prices. Exponential and weighted averages apply more weight to recent prices of the stock or commodity being followed.
Triangular averages apply more weight to prices in the middle of the time period. And variable moving averages change the weighted based on the volatility of prices.
Steven B. Achelis, in his book, Technical Analysis From A to Z, has written one of the most lucid explanations of moving averages that we have read, which we quote from at length:
“The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security’s price with the security’s price itself. A buy signal is generated when the security’s price rises above its moving average, and a sell signal is generated when the security’s price falls below its moving average.
Continues Achelis: “This type of moving average trading system is not intended to get you in at the exact bottom nor out at the exact top. Rather, it is designed to keep you in line with the security’s price trend by buying shortly after the security’s price bottoms and selling shortly after it tops.
“The critical element in a moving average is the number of time periods used in calculating the average. When using hindsight, you can always find a moving average that would have been profitable…. The key is to find a moving average that will be consistently profitable. The most popular moving average is the 39-week (or 200-day) moving average.
This moving average has an excellent track record in timing the major (long-term) market cycles.
“The length of a moving average should fit the market cycle you wish to follow. For example, if you determine that a security has a 40-day peak-to-peak cycle, the ideal moving average length would be 21 days calculated using the following formula:
Continues Achelis: “Moving averages can also be calculated and plotted on indicators. The interpretation of an indicator’s moving average is similar to the interpretation of a security’s moving average:
- When the indicator rises above its moving average, it signifies a continued upward movement by the indicator;
- When the indicator falls below its moving average, it signifies a continued downward movement
by the indicator.”
Indeed, many and varied are the uses for moving averages, whether used on prices or technical indicators of prices. In this book, we will concentrate primarily on price-only simple moving averages of short-term and intermediate-term time frames.