This is the most widely used and is simply calculated by adding up a set of values and dividing the total by the number in the set. This is the average. Movement of this average is effected by adding the next new value of the set and subtracting the first value of the set and again dividing by the same number of values in the set being studied. You repeat this simple calculation with each new piece of data.
E.g. to find the 3 period average of the following sequence 5,10,8 add the three numbers together which gives 23 and divide that number by 3 which equals 7.7. The graph shows price strength is associated with a rising moving average and that weakness is denoted by a declining moving average.
The shorter the time period calculated, the more volatile the average and the shorter the lag period but the more frequent will be costly whipsaws.
Longer time periods will be less volatile with fewer whipsaws but the lag period will be greatly increased substantially eroding profits.
In the last example we have three MAs 4, 9 and 18. These help represent the short, medium and long term trend.
When the 4 and 9 period moving average cross we have a potential buy or sell signal. When the price returns to the faster MA and closes above all three averages, this is a an opportunity to buy or sell.
1. The moving average is similar to a smoothed trend and as such often acts as an area of support or resistance.
Retracement of prices often reverse when they reach the MA level, i.e. in a rising trend a falling price often finds support and in a falling market rising stock prices often find resistance when they reach the level of the moving average.
2. The penetration or cross over of a MA (and therefore of a smoothed line of support or resistance) by price is frequently the signal of a trend reversal.
3. If the moving average has flattened out or has already reversed direction then its violation increases the likelihood of a reversal of the recent trend.
4. The longer the time span used to calculate the MAs the greater the significance of its violation by price, e.g. a 200-week moving average violation by price is of more significance than that of a four week moving average, which is of more significance than that of a four day moving average.
Any time span can be considered from minutes to years. An appropriate choice relevant to one's trading style is the most obvious.
If you are a very short term trader, then a moving average of as little as three days may be appropriate.
However in a sideways moving market you can become out of sync with the trend and spend a lot of time being whipsawed. The normal bull/bear market cycle, usually 4 years in duration, would be entirely missed by choosing a four year moving average, a two year average would be frustratingly slow and you would be in and out of the market too late to make much, if any, profit. Yet a short period e.g. a 10-day moving average would likely whipsaw you in and out the market too frequently to be very profitable.
Different markets, different market cycles and different investor goals will determine the most appropriate time period for which to calculate the moving average. Some commonly used ones are:
- Major primary trend monitored by a 40-week (200-day) MA.
- Intermediate term trend by a 40 day MA.
- Short term trend by a 20-day MA.
Author Resource:-
Martin Chandra is a full-time investor. He has been researching investment strategies and make his own living. For more information please go to here.
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