10.9 Moving averages

Hanumant Dhokle

Technical analysis using moving averages

Moving averages are one of the most popular and easy to use tools available to the technical analyst. They help smoothen a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays. The simple moving average is the most widely used. (There is also an exponential moving average - see the reference). Simple moving average calculation is shown below in mathematical form and displayed in the chart on the right. For example: A five-day simple moving average is calculated by adding the closing prices for the last five days and dividing the total by five.

10+ 11 + 12 + 13 + 14 = 60

(60 / 5) = 12

The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curving line – the moving average line. You add each new closing and skip the oldest. Thus, the sum of closings always remains constant at five days. Whether you choose a 10-day average or a 40-week average, the calculation is the same. Instead of adding five days you add 10 days or 40 weeks and divide the sum by 10 or 40 respectively. So it is very easy to understand and also very useful in analyzing market trends.

'Buy' arrows were drawn in the chart above when Aflac's price rose above its 200-day moving average. 'Sell' arrows were drawn when Aflac’s price fell below its 200-day moving average. Long-term trends are often isolated using a 200-day moving average. You can also use computer software to automatically determine the optimum number of time periods. Ignoring commissions, higher profits are usually found using shorter moving averages. The uses for moving averages are as below:

A) Trend Identification/Confirmation

There are three ways to identify the direction of the trend with moving averages:

  1. Direction of moving averages to determine a trend.
  2. Location of price relative to the moving average - if the price is above the moving average the trend is considered up and vice versa.
  3. Crossovers in terms of the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up and vice versa.

B) Support and Resistance Levels

Another use of moving averages is to identify support and resistance levels (as explained in the trends). This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.

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