Credit: Shutterstock photoA moving average is a popular technical analysis tool used to reflect trends in the stock market and individual equities. Option traders use moving averages to determine which direction an equity's price is likely to move over a specific time frame, and ultimately establish a position aligned with the estimated direction.
Moving averages are calculated using an equity's past price performance, and they eliminate irregular fluctuations or day-to-day "noise" to provide a cleaner view of the stock's trend. There are three common methods to calculate moving averages: simple, weighted, and exponential.
Simple Moving Averages
Simple moving averages involve a fairly basic calculation: Add a stock's closing prices over a set number of days, and then divide the sum by the total number of days. For example, a 20-day simple moving average divides the sum of stock XYZ's 20 most recent daily closing prices by 20. The resulting figure provides stock XYZ's average price over the preceding 20-day time frame, and becomes that day's plot point within the trendline. With each new day, the most recent closing price replaces the oldest closing price in the calculation.
Although simple moving averages are the most common, some criticize the method for giving equal weight to each closing price in the data set instead of placing more significance on the most recent closing prices.
Weighted and Exponential Moving Averages
Unlike simple moving averages, weighted and exponential moving averages assign greater significance to a stock's most recent closing prices. Weighted moving averages use a calculation similar to simple moving averages, except each closing price is assigned a weighting.
Heavier weightings are assigned to the most recent closing prices in the data set to ensure the moving average reflects recent trends and fluctuations. For example, a trader assigns a weighting of one to the first closing price in a 10-day weighted moving average and a weighting of 10 to the tenth day's closing price, giving the most recent closing price 10 times more significance than the oldest closing price.
Exponential moving averages assign a fixed percentage weight to a stock's most recent closing prices to give greater significance to more current values. Exponential moving averages react to recent price movement more quickly than simple moving averages, which could translate into a faster entry or exit point for a trade.
Popular Moving Average Time Frames
Moving averages can be applied to any time frame -- days, weeks, months, or even 5-minute increments. A shorter time frame provides a closer reflection of the stock's recent movement. Traders commonly use 10-day, 20-day, and 50-day moving averages to identify shorter-term trends and possible imminent trend changes.
Longer time frames produce smoother averages, since a broader swath of daily closing prices will be figured into the calculation. Some of the more widely followed longer-term moving averages include the 100-day and 200-day.
Interpreting Moving Averages
While there are several ways to calculate moving averages, each moving average shows us the same kind of information.
The direction of a moving average tells you the general direction in which the price is moving. If the moving average is angled up, the price is, or recently was, increasing. The opposite is true if the moving average is angled down. If the moving average appears to be moving sideways, the stock is in a trading range.
The slope of a moving average indicates the strength of a stock price's current trend, particularly when viewed within the context of additional trendlines. A short-term moving average that rises above a longer-term moving average indicates the trend is bullish, whereas short-term moving averages that cross below longer-term moving averages confirm that the trend is bearish.
Moving averages can serve as support or resistance for a stock's price, so traders will want to watch the charts to see how a stock has fared after previous meet-ups with various trendlines. If a stock has bounced from a specific moving average on multiple occasions, that trendline can be viewed as a likely area of support, and a potential entry point for a bullish trade. Conversely, a trendline that has repeatedly rejected a stock's rally attempts is considered to be resistance, and can provide entry points for bearish plays.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
