Methodology

Stocks

Module 4

Moving Averages

The concept of a moving average is based on the idea that an investor can calculate the average price of a stock over a period of time. As time passes by, the moving average will change as the price of a stock goes up and down.  

 

Investors that use this concept are tracking the moving average of a stock, in hope that the stock price will go above the moving average. They believe that when this happens, the stock price will go up.  Similarly, if the stock price moves below the moving average, it is thought that the stock price will go down.

 

Moving averages are typically used by investors with a short term strategy (i.e. day traders or swing traders). They are generally the individuals that use technical analysis the most, as they rely on stock chart data.

How are moving averages calculated?

The moving average is calculated by adding each stock price for a particular timeframe together. This figure is then dividing by the number of total stock prices used. For example, if the price of a stock is $12 at 12 pm, $14 at 1 pm and $11 at 2 pm, the moving average would be: ($12 + $14 + $11) ÷ 3 = $12.33. 

 

So, you would simply add each stock price together and divide them by how many there are (in this case, there are 3). Therefore, if the current stock price is higher than this number (i.e. $12.50), day traders and swing traders will typically think of it as an opportunity to buy, as they think that the stock price will go up.

 

The timeframe that you use to calculate the moving average of a stock, should be the same as the timeframe that you typically hold an investment for. For example, for a day trader, this would obviously just be for 1 day.

A key drawback of moving averages

Moving averages rely on historic chart data, which is a major drawback as the information may be totally irrelevant to what actually happens to the stock in the future. As a consequence, the moving average calculation may produce outcomes that are not useful or that are random. This is especially true if a stock is very volatile and is moving up and down very aggressively.

 

At times, a moving average may give you false signals, as it is not an exact science. Instead, it is more so a statistical technique that indicates that the price of a stock is likely to increase, based on recent information. The moving average calculation tends to work best when there is an obvious trend in the stock market data. However, it is arguable that it is common sense to predict that an uptrend will continue, with the moving average calculation not being necessary.

 

For that reason, it has limited usefulness, when it comes to making investment decisions.

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