6.2.4. Moving Averages
Another technique of technical analysis used in coordination with chart analysis is the moving average. A moving average is an average calculated over a fixed period of time. It might be the average of the last five days of closing prices, or the last ten days of midpoint prices. It is called a moving average because it is continually recalculated as time moves forward. Each day, for example, the previous ten days are used. Yesterday’s tenth day will drop off and be replaced by today’s closing price.
The moving average may be calculated in one of several ways. The simple moving average gives equal weight to each day’s price and is the kind most commonly used. Other moving averages use various techniques to weight the most recent days more heavily. The length of a moving average depends on the uses to which it is applied. Moving averages ranging from 10 to 30 weeks are often used in the stock markets. Commodities markets use shorter-term moving averages that are linked to some multiple of the monthly (20-day) trading cycle. A 5-, 10-, 20-, or 40-day moving average is common.
Unlike charting, moving averages have no predictive powers. They are used to smooth out a trend line, to reveal more clearly an underlying pattern. The moving average does not anticipate changes but simply tracks the progress of a trend. A shorter (five-day) moving average is more sensitive to price changes, making it useful for following sideways patterns. A longer moving average shows a trend more smoothly and is most useful when trends are securely underway. The shorter moving average is more prone to send false signals; the longer moving average will be slower to recognize reversals.
Analysts may use a simple moving average in conjunction with the bar charts to identify trend signals. They plot the moving average on the chart overlaying its daily price activity. A closing price above the moving average is a buy signal. A sell signal is generated w