Those who trade stocks would clearly like to know the direction in which stocks are moving. They would like to know whether a stock has reached its lowest point or its highest level within a time frame. But such calls are tough to make. As a result, methods have been developed to assist traders in determining stock trends. Among those methods are moving averages. A rising moving average shows prices are gaining, whereas a falling moving average indicates prices are slipping.
A moving average cannot determine the exact bottom or high of a stock, but it can help to identify a trend and enable the trader to get in or out of a stock closer to the bottom or top than might otherwise be the case. Traders using UltraTrade might therefore consider adopting moving averages as tools in their arsenals.
How moving averages are calculated
A moving average is a calculation based on a stock’s daily price (usually the closing price) over a certain period of time. Adding the daily prices over, say, 10 days, and dividing by the number of days determines the moving average for that time period. In that way, the daily swings are lessened and the trend is easier to identify.
Any number of trading days can be selected to determine the average. A short time frame such as 10 days is a measure to determine the short-term trend and a long time frame, such as 200 days, indicates the long-term trend. Of course, medium time frames, such as 50 days, can be used as well and are among the most popular. The average is calculated daily. A 20-day moving average will be re-calculated each day based on the previous 20 days, hence the term “moving.” Each day’s average is recorded and tracked over time.
Moving averages on their own are a lagging indicator because they show where a stock has been and are useful as an indication of a recent trend, but not necessarily as an indication of where a stock may be headed, unless a trader believes the trend will continue.
The longer the time period that is covered by the moving average, the more of a lagging indicator it becomes. A 10-day moving average, for example, will show how prices have been trending over the last 10 days and so will be up to date. When the average covers 200 days, however, the average includes prices that go back a long time and it therefore takes a longer time for the trend to change. Traders generally choose the moving average that fits more closely to the time frame in which they trade. Those who actively trade will watch a short-term moving average and those who trade less often will move to the longer term moving average.
How traders use moving averages
To determine where a stock may go next, most traders compare the moving average with the daily stock price. For example, if the moving average of a stock calculated over the past 20 days is 15 and the stock is trading today at 16, it has broken through the moving average to the upside. Such a move can be interpreted as a buy signal as the trend is upward. A break to the downside could be interpreted as a sell signal.
Moving averages can become quite complicated when other calculations, such as price weighting, are added into the mix and when various methods of calculating moving averages are combined in a variety of ways. All are aimed at trying to get a better handle on how stocks are trending and where they are headed.
Types of moving averages
A simple moving average is calculated by totaling the closing prices over the time selected and dividing the total by the number of days.
An exponential moving average is aimed at making the average more up to date. Additional weight is placed on the most recent stock prices. Other methods, such as triangular and variable, place the weight on the middle portion of the prices or smooth out the prices according to a formula based on volatility.
Experts disagree on which method is best. Because the selection of a moving average depends on a trader’s goals, style of analysis and time frame (short-term or long-term) traders are advised to experiment with all kinds of moving averages to determine what works best for them. They should look at a stock and track its moving average over time, say the past 50 days, using a variety of methods and determine which was the best indicator of the future trend of the stock based on their trading philosophy. That way, traders using UltraTrade will be able to determine which type of moving average and which combination of averages is best for them.