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What is a moving average?

Moving averages are very often used as a technical indicator and are designed to smooth out fluctuations in value by creating a constantly updated price average. 

What is it for? To help traders see the direction of a stock’s trend or its support and resistance levels. As price moves in zigzags, the moving average smoothes out these movements and makes it possible to determine the direction of the trend.

Moving averages are averages of price movements over a period of time. To build such a graph you must calculate the arithmetic average of the price. Thus, if it is a weekly format, we add the closing prices of the last seven days and divide them by their number.

Here’s how it looks on the graph:

Based on the calculations, we build a curve that will display the current trend. An uptrend is when the chart is moving up, and a downtrend when it is moving down. However, since the moving average has a tendency to lag, it is better to use additional indicators to determine the trend. When combined with a moving average they can give a fairly accurate idea of the trend.

The longer period of time the moving average covers, the more it will lag, because it is based on past prices. It turns out that a 200-day moving average will lag more than a 20-day moving average.

Moving averages can be customized, that is, an investor is free to choose any time period to calculate the average. The most often used time periods are 15,20,30,50, 100 and 200 days.

Short-term moving averages are used for short-term trading, while longer averages are more appropriate for long-term investors. It is impossible to predict the exact price movement, but you can get close to it, using technical indicators, including moving averages.

Besides its own value, calculation of moving averages serves as a base for such indicator as convergence-divergence of moving averages (MACD). It is calculated by subtracting the 26-day exponential moving average from the 12-day exponential moving average.

If the MACD is positive, the short-term average is above the long-term average, and that is a sign that the momentum is upward. 

If the short-term average is below the long-term average it means that the momentum is downward.

Additionally, investors are watching for movement above or below the zero line. Above zero it is a signal to buy, below zero it is a signal to sell.

As you can see, simple calculations give enough information to make further price predictions.

And in the next lesson we will consider what types of moving averages there are.