Moving averages are a form of stock chart or so-called technical analysis. With this method, you look at the chart of a single stock and make predictions as to whether it is relatively high or low at the current price.
The moving average (short MA) of a stock is calculated from historical stock prices, it is an average of the stock price over a period of time prior to the actual day. This period of time is also called a time window. The length of the time period is the most important variable for the calculation. A very common time window for MAs is 200 days, which means that the average is calculated using the share price of the last 200 days. The term “movement” comes from the fact that the time window slides along the stock price chart as time progresses.
Calculating an MA gives you a trend line from a stock or indices chart. This trend line smooths out the ups and downs that occur all the time in the market and can show strong trends more clearly. By looking at the trend line, you can quickly get an overview of how the stock has been moving and avoid investing when it is in a down move, and instead invest in a bull market.
Even better, by comparing the actual price of the stock to its moving average, you can make assumptions about the strength of the move, expressed by how far the current price is from its average.
The most common use of moving averages is to use them as a trading signal, telling you to buy or sell a stock. The easiest way to do this is to treat the crossing of the stock chart line with the moving average line as a signal: if the stock price falls through the moving average, it is a signal to sell, when it happens otherwise, it is a signal to buy. The big problem with this strategy is that ‘false signals’ can often occur. False signals are signals that don’t turn out to be correct, for example when the MA crosses the stock from the bottom to the top signaling a ‘buy’, but soon after falls back below the average, signaling a ‘sell’. The problem with that is that there may have been little or no gain in the stock price, but the buying and selling process costs money in the form of, say, broker fees.
To reduce the false signal effect, there is the method of not using MA + share price, but MA + another MA. If you look at a stock chart, you’ll see that it has a lot of ups and downs, it’s very spiky. Now these spikes pose a problem as they can go through the MA and back shortly after, causing a false signal and an unnecessary trade. Now if you look at a moving average you will see that it has no spikes as it smooths them out due to its averaging. Therefore, using a ‘moving average crossing a moving average’ method is less likely to produce false signals. The time windows for the two averages should be different from the course, a common approach is to take 200 days for the long and 50 or 38 days for the short.
