Moving Average

A moving average is a tool used by investors in the stock market, and the purchase and sale of other financial instruments, that track trends and momentum in the market. A moving average is created by taking a set number of data points, representing the closing price of a particular stock on a particular day, and averaging them to create vector showing the way the financial instrument has traded over a period of time. For example, if you wanted to create a moving average for a particular stock over the past month you would take the closing price of the stock for the last 30 days; add them together; and divide by 30. This will give you the moving average.

If you were to continue to add to this average over a course of time the data points would become more and more diluted and tend to make the average meaningless. The moving average corrects this by deleting the last data point in the sequence for every addition to the moving average. For example, if you have a 30 day moving average, on the second day of your moving average you will delete day 1 as you add day 31. In how the definition of “moving” average comes about.

An investor can create a moving average for any amount of time he, or she, wishes. The goal in creating different moving averages of different lengths is to track short and long term trending of a particular financial instrument. Moving averages at or below 20 days are categorized as short term moving averages. Those between 20 and 100 days are considered to be medium term where above 100 are long term. Depending on the type of trading you are involved in you will want to design your moving average in a way that will be most beneficial to you. A day trader may want a moving average that recomputes every 50 minutes where someone looking at blue chip stocks may want to look at trends over a 300 day period.

There are two main types of moving averages. There is the simple moving average, SMA, and the exponential moving average, EMA. The simple moving average is prevalent amongst beginning investors in that it is, by its name, simple to compute. The Simple Moving Average is computed by weighing each data point equally. In contrast, the Exponential Moving Average is computed by weighing the most recent data points more heavily than those from farther in the past. The Exponential Moving Average is considered to be more reliable and better reflects current market trends.

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