Moving averages serve several purposes in regard to trading.
They can be used to establish trends, for trade entry and exit signals, or used to determine the overall market bias.
For the particular style of stock option trading I'm sharing with you, we will primarily use them to help us determine the trend and for entry and exit signals.
Let's begin by going over the basics.
A moving average (MA) is a line overlaid on a stock chart that displays the price trend over a certain period of time. You can use any period of time that you like (weeks, days, minutes, etc.).
While it's possible to create moving averages from the Open, the High, and the Low data points, most are created using the closing price.
For instance a 3-day MA is calculated by adding the closing prices for the last 3 days and dividing the total by 3.
15 + 16 + 17 = 48
(48 / 3) = 16
This data point (16) is then plotted on a chart. Tomorrow the very same calculation is performed except the oldest day (15) is dropped and a new day (18) is added.
16 + 17 + 18 = 51
(51 / 3) = 17
The new average will be slightly different because a new closing price has replaced one of the previous 3 closing price points.
This new point is also plotted on the chart. The process is repeated each day for the selected time period. As the average prices are plotted on the chart, they are connected by a line.
The picture below shows an example of a 7 and 30-day MA overlaid on a stock chart.
The shorter the time period (5, 7 day), the closer the average will mimic price movement. The longer the time period (30, 200 day), the longer it takes for the average to "catch up" with the price movement.
All moving averages are called lagging indicators. They lag "behind" price movement; they always happen after the fact.
Notice in the picture how prices are already trending in a certain direction before the average changes direction. This is best seen in the 30-day MA.
Simple: A SMA gives equal weight to each price point over the specified period. The SMA is probably the most widely used moving average.
Exponential: An EMA assigns more value or weight to recent prices instead of giving equal weight to all prices as does the SMA. The weighting for each older data point decreases exponentially, giving much more importance to recent observations while still not discarding older observations entirely.
Weighted: The WMA is another moving average that gives more emphasis to the latest data, but the calculations are more involved. A weight is assigned to each data point in the average. Each day is multiplied by its assigning weight and all the weighted prices are added together and then divided by the total number of weights.
The SMA is least reactive to price changes. The WMA is most reactive to price changes, and the EMA is somewhere in the middle.
As you learn more about trading you will find that when prices are trending, moving averages work well. However, when prices are not trending, they are not as useful.
The lesson was meant to be an overview to help you become familiar with moving averages. As we proceed further in the learning tutorials I'll show you how to use them for trading purposes.
Proceed to Lesson 8: Stock Volume.
Module 4: Stock Charts