We’re starting a new series that focuses on technical indicators. We’ve already covered relative strength. This time, we’re looking at moving averages.
What is a moving average? A moving average aims to measure the price trend of an investment over a period of time – often 50 or 200 days. A simple 200-day moving average is calculated by adding up an investment’s prices over the past 200 days and then dividing that sum by 200 (the number of days). There are also exponential moving averages, which give more weight to more recent prices.
Moving averages are considered “moving” because they move forward each day, adding a new price point. This is similar to the FundX Score we use in NoLoad FundX, but our scoring system moves forward on a monthly basis, adding the most recent month of performance to our calculations and losing the oldest month of performance.
Why do investors use moving averages? Averaging a security’s price over weeks (20 day), months (50 day), or even the last year (200 day) is a way to smooth the bumps in a security’s returns over time, and plotting a moving average makes it easy to see changes in trend direction. The direction of a moving average helps investors identify if a security is trending up or down on a short-term (20 day) or longer (200 day) basis.
When the current price of a security is above the moving average, it implies that the security is higher today than its average price over the moving average period. This is often considered a positive sign. When a security is trading below its moving average, it is often considered a negative sign.
Some traders focus on the direction, or slope, of a security’s moving average rather than on its current price. For example, if a security’s moving average is rising and the current price is below that average, some traders believe this represents a buying opportunity. On the other hand, if the security’s moving average is falling and the security is trading below the average, this merely confirms the down trend.
Limitations of Moving Averages. A moving average only tells you about a single security; it doesn’t help you compare securities. To compare funds and ETFs, we use the FundX Score. Like a moving average, the FundX Score smoothes out the bumps in returns over time and it focuses on trends, but the FundX Score aims to track leadership trends, not directional trends.
Want to learn more about moving averages? Stockcharts.com has a good introduction including charts of simple and exponential moving averages.