The moving average is probably THE basic tool of technical analysis. It is used on its own, as well as in combination with other moving averages and even as moving averages of moving averages. It is also one of the most basic of building blocks of many more technical indicators and tools.
The basic moving average is fairly simple to figure, even by hand. To calculate a moving average you must identify two things: 1. The number of days you choose to target in your analysis. 2. The price of the specific item for each day during the target period. To find the moving average of your specific item you must tally up all the prices during your target period giving you a grand total. Divide the grand total by the number of days in the target period. This figure is your Moving Average.
The next day you must subtract the closing price of day 1 from your grand total and add the current days closing price. Divide the grand total by the number of days. This new number is the new average, hence the name Moving Average.
Simple moving averages apply equal weight to the data used to construct the average; all the data is treated equally. It gets fairly complicated when you start using exponential, weighted, time series, triangular, variable and volume adjusted moving averages.
These assign different weights or variables to the moving average and can significantly alter the resulting values obtained. Exponential and weighted averages apply more relevance or weight to recent prices. Triangular averages apply more weight to the middle of the designated time period. Variable weighted averages adjust according to the volatility of the prices and volume adjusted are factored using the volume of the price of the base security.
Probably the most basic indicator used in analysis today is the 200 day moving average of a security or a market. Even fundamentalist pay attention to this indicator.
This average is obtained by adding the last 200 days of closing prices for the security/market and dividing by 200 to plot the value. It is commonly thought you should be bullish, long term, on the security if the closing price is trending above the 200 day moving average. Conversely, if it is below it's 200 day moving average you might be bearish on the security.
One of the basic tools which everyone should explore and understand is a basic crossover moving average indicator. This is constructed of a moving average with the closing price of the security or market used as the 2nd point.
This simple system gives a buy signal when the price moves above the moving average such as the 200 day moving average discussed above. It is also quite common to apply another average of another duration to add into the equation for a total of 3 plotted points. In this case, a buy signal is issued when the price of the security moves above the shorter time period moving average which is also above the longer time period moving average.
It would signal a sell signal when the price moves below the shorter term moving average which is also below the longer time period moving average. The problem, for us comes from trying to figure what time periods to use for the equation, as that is the most critical element used in these systems.
Using hindsight or testing by way of a computer, may very well tell you what is the best period of time to use. Using these methods, you may optimize the number of moving average time periods to use in that particular security or market for the most profit possible over that back tested period of time.
The moving average should fit the market cycle you wish to follow or that would result in the highest profits for that period of time and that particular security. The problem is always you are testing for "the most profit possible over that back tested period of time" and you know as well as I, the market's and security's characteristics change constantly.
So what works today, may not work tomorrow but will work again in a couple of weeks or months. This is one of the primary shortcomings of a simple crossover moving average indicator even when it has been tested and refined to work on a particular security.
Many times moving averages are used to "smooth" another indicator which may be so erratic to make it's value useless. Such as, if a stochastic indicator is too volatile to be of use by itself. You may want to plot a moving average of the stochastic and just use it in your analysis and ignore the indicator itself.
Whipsaws are thereby reduced and provide a more smoothed indication of the direction of the indicator itself. This works well with the MACD, momentum and stochastic type of oscillators. All of these indicators will be discussed in a later issue.
Standard technical analysis and most data providers give you the open, high, low, close and volume of the security your are requesting. In most analysis, you see published, it is the closing price which is used for the analysis, be it with moving averages or any other indicator unless in the design of the indicator itself, it is written to use those other data points.
Why not investigate moving averages with the open used instead of the close, the spread between the high and the low or the highs or the lows themselves? I have not seen any studies, recently, using these other prices points which are provided by the data services; they tend to be largely ignored.
Those data points are there to be used and analyzed. It doesn't cost any more to get them and maybe, just maybe, you could come up with something new and revolutionary.