Moving Average
What is moving average?
Moving average is an indicator used in technical analysis that shows a stock's average price over a certain period of time. It is good to show a stock's "momentum" and it's propensity to move above or below a point. Generally moving average is plotted on a graph alongside the stock's price. For example, a picture of a stock's moving average along with its price is below (Dell's 50-day moving average):
How do you find moving average?
There are different types of moving average, and therefore different formulas to calculate it. However, for any given moment in time, the moving average is the average of the stock prices over the past x days, where x is the period that you are measuring. For example, if the stock price on Monday was $3, the price on Tuesday was $5, and the price on Wednesday was $7, the three-day moving average on Thursday would be $5, or the average of the past three days.
Why is it important?
Moving average can be a better indicator of the stock's average price over time than the stock price. The moving average curve is a much smoother version of the price curve because it eliminates all of the sharp bumps that are caused by short deviations.
What are some different types of moving averages?
Two of the most important types of moving average are linear moving average (this is generally just called "moving average") and exponential moving average. Linear moving average is the more simple one, and just consists of the average derived by summing up all of the stock prices and dividing by the number of stock prices. In an exponential moving average, the more recent days are given exponentially more weight, and it uses a much more complicated formula to find the average. There is no one formula because one can weight the days differently. For example, in a ten day EMA, you could give the last day a weight of 20%, the second-to-last day a weight of 14%, etc. Some common time frames for both moving averages are 5, 10, 20, 50, 100, and 200 days.
How can I take advantage of the "crossover" principle of moving averages?
The "crossover" principle of moving averages is very important to investing. Whenever a stock price goes below its moving average, that means that it has downward momentum and it is not a good buy. If you have the stock, you should think about selling it. Whenever a stock price goes above its moving average, that means that it has upward momentum and it is a good buy. The Google graph with 50 day MA below gives an example:
The stock was a good buy between November 2005 and January 2006, but not between February 2006 and March 2006, according to the moving average.