Moving averages are widely used technical indicators to filter out short term fluctuation and pin point a stock (market) trend.

Moving averages are one of the most popular and easy to use tools available to the technical analyst. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.

The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are described in more detail below.

A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.

In order to reduce the lag in simple moving averages, technicians often use exponential moving averages (also called exponentially weighted moving averages). EMA’s reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA’s period, the more weight that will be applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while a 20-period EMA weighs the most recent price 9.52%.

In ValidFi, moving averages by default are for Total Returns of the underlying security. That means, for a mutual fund or ETF, their dividends and distributions are reinvested and taken into account when a MA is calculated. This is an especially important consideration for high yielding securities.

The Way to Analyze Moving Averages

Find Moving Average and price chart cross-point. If the price line crosses the Moving Average line from below, then this is a signal to buy. If it crosses from above, then it is time to sell.

This strategy has two parameters to allow users to set up:

1. Which method users prefer to analyze the security (market), SMA or EMA. The default value is “true” for SMA method.
2. What security users want to analyze.
3. Number of days the simple moving average is based.

Moving Averages As Trend Indicators

Aside from being used as actual trading signals, MAs are also used to pin point a security's trend. For example, for a short term trend, 5 day SMA line could be used to see a short term security price trend. If the SMA 5 days is increasing, the security price is trending up or vice versus. The SMA 200 days has been widely used as the long term trend, not only for stocks (markets), but also for many economic indicators.

Model Portfolios

In this strategy, MAs with a parameter of the number of days are used for several representative stock indices including S&P 500 (index ^GSPC), Russell 2000 (index ^RUT) and Nasdaq 100 (index ^NDX). A dividend reinvested Vanguard 500 VFINX is also used. Users are encouraged to create their own portfolios to keep track of a particular fund or indices.

The following is a list of other possible applications of Moving Averages (MAs).

• Moving Averages With Signal: Use one security's MA as the trading signal for the other security or even a portfolio.
• Moving Average Short: Use Moving Average as a downside protection by shorting another security similar or related to the underlying security. Another similar strategy is the Momentum Hedge, which utilizes MAs are the downside protection for a momentum based portfolio,
• Moving Average With Two Signals: Instead of merely using one signal, use multiple signals (two signals) to make sure the trends are confirmed.

See Also

• Masonson, Les. All about Market Timing. McGraw-Hill Companies,  2003. pg 131-152. 
• "Moving Averages", StockCharts.com - ChartSchool.
  
• "Moving Averages", Wikipedia.