Moving Averages

One of the first things many people do when they hear about a new stock, ETFGlossary: A fund that holds a basket of investments, like stocks or bonds, and trades on an exchange like a single stock. One share gives you a slice of everything the fund owns., or mutual fund is pull up its chart. In our previous article, “Trendlines”, we discussed simple methods to properly draw trendlinesGlossary: A line drawn across a series of price highs or lows on a chart to show the direction prices have been moving. A clean break through it can signal the trend is changing. and determine whether we are in an ‘uptrendGlossary: An uptrend is a price that keeps making higher highs and higher lows over months; a downtrend is the reverse. A common test is whether the price is above or below its long-term moving average.’, a ‘downtrend’, or ‘consolidating’. All investments fall into one of those three categories regardless of whether it’s a chip stock like Micron, a futures contract for Cotton, or the 2-year Japanese Government BondGlossary: A loan you make to a government or company. It pays interest on a set schedule and returns the amount you lent when it matures. When interest rates rise, existing bonds lose value.. In this paper, we’re going to take our trend analysis a step further and look at moving averagesGlossary: The average closing price over a set number of recent days, recalculated every day. It smooths out day-to-day noise to show the underlying trend..

A simple moving average “simply” takes an average of the price of whatever instrument we’re looking at over X number of days. For clarity, it adds all those prices up and divides by the X to determine the ‘average price’ over that many days. Sounds simple enough. It doesn’t require much beyond 5th grade math, and every platform I’m aware of online that shows charts also has moving averages. But don’t let the simplicity fool you — as we’ll see, moving averages are incredibly powerful.