The most commonly used indicator by far is the moving average. Its value is easy to understand intuitively and one of the least controversial indicators. Almost any trader will agree to the value of moving averages.

Moving Average Basics

A moving average represents the average value of an issue over a trailing window.  All moving averages are designated in terms of a time span for how many days of trailing data should be included in the average.  For example, 10 day, 50 day and 200 day moving averages are commonly used.  There are however several ways to calculate this average.  The two most common are the simple moving average and the exponential moving average.

Simple Moving Average

The simple moving average is the most obvious type of moving average.  For an X day moving average you simply total the values of the previous X days and divide by X.  However, in addition to being simple, this method of calculation is somewhat volatile.  The fact that all days are given an equal impact on the average leads to a high sensitivity to the value that has just dropped out of the window.

Exponential Moving Average

In an exponential moving average, or EMA the weight of each piece of data decays as it gets farther from the present.  While much harder to calculate, these tend to give results that are less subject noise.  The impact of each day decays exponentially as it gets farther from the present and thus the most recent data is the most influential.

Trading with Moving Averages

Using these moving averages is fairly straightforward.  In general you want to be trading in the direction of the moving average, however there are some caveats:

When price has deviated particularly far from its moving average, there is a good chance it will return and “touch” the MA again.  This deviation can be a good opportunity to take profits and re-enter the position when it returns to the moving average.

When a price crosses a moving average, this can indicate a change in trend direction.  Many traders will use this as an indicator for a trend change.

Moving averages are integral to trading and are also pivotal in calculating other indicators.  They are the basis of most numeric analysis of stocks and understanding them is very important.

Types of Moving Averages

There are many ways to calculate moving averages.  The first is a simple moving average in which a given number of days’ values are added up and then divided by the number of days.  So for example to calculate a 10 day simple moving average of closing price we would add up the previous 10 days’ close and then divide them by 10.  As we did this daily the plotted points would form a useful indicator.

While the simple moving average is handy because it is easy to calculate, an exponential moving average is more commonly used.  In this type of moving average the weight of each day’s data decreases as you get further from the current period.  Thus as a day gets further in the past its influence on the moving average becomes less, instead of simply disappearing on the day it moves out of the term.  While there are many other ways to calculate moving averages, these two are the most commonly used.

Using the Averages

Moving averages have many ways they can be used in trading.  Prices often have a tendency to “bounce off” of the averages as they trend.  As a stock trends up it tends to stay above its moving average but also tends to touch it periodically in the process.  This can be useful in identifying what kind of trend you are in for different periods.  Traders will often use a 10 day EMA for a short term trend, a 50 day EMA for a medium term trend and a 200 day EMA for a long term trend.

Also with the different time periods associated with these different trends, you can use moving average crossovers as a signal.  This is the basis of the MACD histogram.  Watching the convergence and divergence of different moving average periods can give you insight into how each trend is changing relatively.

Price crossovers can also be used to watch for a change in trend.  If a chart has been trending in one direction, staying above its EMA and then crosses over to the other side, this can be an indicator that the trend has ended.  This can be a good time to either close or open a position.

Moving averages are one of the most fundamental concepts to understand in your technical analysis education.  Many other indicators are based on them in one way or another.   Even if you eschew more complicated indicators they can be useful in simple chart analysis and should be part of any trader’s understanding.