MOVING
AVERAGES
Moving Averages
Moving averages are one of the
oldest and most popular technical analysis tools.
This chapter describes the basic calculation
and interpretation of moving averages. Full
details on moving averages are provided in Part
Two.
A moving average is the average
price of a security at a given time. When calculating
a moving average, you specify the time span
to calculate the average price (e.g., 25 days).
A "simple" moving
average is calculated by adding the security's
prices for the most recent "n" time
periods and then dividing by "n."
For example, adding the closing prices of a
security for most recent 25 days and then dividing
by 25. The result is the security's average
price over the last 25 days. This calculation
is done for each period in the chart.
Note
that a moving average cannot be calculated until
you have "n" time periods of data.
For example, you cannot display a 25day moving
average until the 25th day in a chart.
Figure
23 shows a 25day simple moving average of the
closing price of Caterpillar.
Figure 23
Since the moving average in
this chart is the average price of the security
over the last 25 days, it represents the consensus
of investor expectations over the last 25 days.
If the security's price is above its moving
average, it means that investor's current expectations
(i.e., the current price) are higher than their
average expectations over the last 25 days,
and that investors are becoming increasingly
bullish on the security. Conversely, if today's
price is below its moving average, it shows
that current expectations are below average
expectations over the last 25 days.
The
classic interpretation of a moving average is
to use it to observe changes in prices. Investors
typically buy when a security's price rises
above its moving average and sell when the price
falls below its moving average.
Time periods in moving
averages
"Buy" arrows were
drawn on the chart in Figure 24 when Aflac's
price rose above its 200day moving average;
"sell" arrows were drawn when Aflac's
price fell below its 200day moving average.
(To simplify the chart, I did not label the
brief periods where Aflac crossed its moving
average for only a few days.)
Figure 24
Longterm trends are often isolated
using a 200day 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.
Merits
The
merit of this type of moving average system
(i.e., buying and selling when prices penetrate
their moving average) is that you will always
be on the "right" side of the marketprices
cannot rise very much without the price rising
above its average price. The disadvantage is
that you will always buy and sell late. If the
trend doesn't last for a significant period
of time, typically twice the length of the moving
average, you'll lose money. This is illustrated
in Figure 25.
Figure 25
Traders' remorse
Moving averages often demonstrate
traders' remorse. As shown in Figure 26, it
is very common for a security to penetrate its
longterm moving average, and then return to
its average before continuing on its way.
Figure 26
You can also use moving averages
to smooth erratic data. The charts in Figure
27 show the 13 year history of the number of
stocks making new highs (upper chart) and a
10week moving average of this value (lower
chart). Note how the moving average makes it
easier to view the true trend of the data.
Figure 27
