Simple Moving Average
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Description
The first technical indicator used in trading was the simple moving average (MAV). It is still one of the most popular. An MAV shows the average value of a security's price over a period of time. For example, the 20-day MAV would normally be calculated by adding up the prices from the past 20 days and dividing them by 20. Since prices are constantly changing, this MAV will also change (or "move"). Each day, the price for the newest day (or period) is added and the price for the oldest day (or period) is dropped in the calculation. Usually the closing - or last - price is used to calculate the moving average.
MAVs are lagging indicators. They are used to emphasise the direction of a trend and to smooth out price and volume fluctuations ("noise") that can confuse interpretation. The most commonly used moving averages are the 20, 30, 50, 100, and 200 day.
Interpretation
MAVs can be compared to the actual price. Each MAV provides a different interpretation on what the security will do. As the period decreases, the sensitivity of the MAV to price changes will increase. However, a shorter period also means that you may have a greater number of false signals.
If the price moves above the MAV and the MAV is directed upward, it can be considered a bullish (buy) signal.
If the price moves below the MAV and the MAV is directed downward, it can be considered a bearish (sell) signal.
Valid buy and sell signals are not given when the MAV changes direction but price does not move above or below the MAV. Another popular technique used for interpreting MAVs is to compare longer-term and shorter-term MAVs with each other.
When a shorter-term MAV moves above a longer term MAV and both MAVs are directed upwards, it can be considered a bullish (buy) signal.
When a shorter-term MAV moves below a longer term MAV and both MAVs are directed downwards, it can be considered a bearish (sell) signal.
Moving averages work best in trending markets. Sideways markets (with no clear upward or downward trends) tend to cause false signals. Analysts often use MAVs with other indicators to confirm price direction. Intersections between MAVs and other indicators (such as an Exponential Moving Average) can be used to pick trend changes.
Advantages and Disadvantages
The advantage of using MAVs is that signals almost always show the "right" side of the market. Prices cannot rise very much without the price rising above its average price. The disadvantage is that trends are usually picked up late. If the trend doesn't last for a significant period of time, then buying/selling late will cause you to lose money.
TIPS:
The trick is to choose appropriate periods. It is wise to test your chosen system extensively on historical transaction data for the security that interests you.
This type of moving average can also be used to smooth out other indicators. Generally, any indicator that appears as a graph below the price chart can be smoothed using a moving average.
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