BALTIMORE (Stockpickr) -- In the world of technical analysis, the moving average, or MA, may well be the most popular indicator out there. But all too often, nascent market technicians only have a passing understanding of the message those added lines on their technical charts are telling them.

 

Today, we’re taking a look at how moving averages work -- and how they can signal trades in the real world.

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    Moving averages are hardly relegated to the world of trading. In fact, it’s a common statistical tool that’s used to interpret large time series datasets by making piecemeal data points relatable to the whole; mathematically, moving averages are smoothing operations that even out statistical outliers and give a clearer picture about the dataset that’s being looked at.

    What that essentially means is that moving averages can take a potentially volatile item like a stock price, and give investors a graph that’s much more indicative of the stock’s overall movement. MAs cut through the noise of the market.

    To put it simply, the moving average is just a rolling average – that is, it’s the average price of a stock over a given number of days. Every day, the most recent day’s data gets added to the moving average and the last day’s data falls off.

    Moving Average Weighting Woes

    But technicians soon discovered a major flaw in this simple moving average (SMA): weighting. After all, price data from nearly a year ago (in the case of the ever-popular 200-day moving average) wasn’t as relevant to today’s market as yesterday’s price; but both had an equal impact on the value of the moving average.

    To remedy that, the exponential moving average, or EMA, became a popular alternative. Unlike the simple moving average, where each day’s prices held the same impact, the EMA is calculated such that each day’s significance decreases exponentially. While other weighting schemes exist, the SMA and EMA are by far the most popular in use by technical analysts today.

    The time period of the moving average is also a crucial element. The most popular alternatives include the 9-day, 50-day, and 200-day moving averages (simple or exponential, depending on the application as well as the trader’s preference). But while daily moving averages, which represent a stock’s price over the trailing X days, are common, it’s essential to remember that moving averages can be used for any timeframe.

    So longer-term traders may find use in the 10-month moving average; whereas day traders may take trading cues from a 50-minute EMA. Ultimately, the right number of periods and the type of moving average depends largely on trading style and the market being traded (i.e. a moving average that’s predictive for equities may not be as useful in the forex or futures markets).

    Ways to Use Moving Averages

    There are three primary ways that stock market technicians use moving averages: to define trends, to find support and resistance levels, and to get actual trade signals.

    Trend is one of the most central tenets of technical analysis. Essentially, the fact that the market moves in trends is one of the main vehicles by which technicians make trading profits; but identifying those trends can be difficult and subjective. With a moving average, though, it’s much more cut and dry.

    When a moving average has a positive slope, there’s a general indication of an uptrend. If a moving average has a negative slope, a downtrend is likely underway. Obviously, the duration of the moving average is key: a nine-day SMA is a whole lot less significant for a trend follower than a 200-day SMA would be.

    Support and resistance are also incredibly important applications of moving averages because they act as a sort of price floor and price ceiling, respectively, for a stock. As such, they can tell a trader where a pullback might be likely to stop or where a rally might be likely to reverse.

    It shouldn’t come as a surprise that moving averages are significant -- because they’re the average price of a stock over a trailing period, they’re essentially the average transaction price for investors who bought or sold during that period. Since past transaction prices (like your cost basis, for instance) play a big role in psychological trading behavior, moving averages can suggest pockets of supply and demand for stocks.

    Of course, moving averages are far from infallible as indicators of support and resistance. A good general rule of thumb is to find a moving average that’s been a good indicator of support and resistance to a given stock in the past, then put it to work going forward.

    As a trading signal, moving averages have historically been an effective foundation for quantitative trading systems (and often an effective way to lose money for traders who based their systems on anecdotal evidence instead of rigorous backtesting). For non-quantitative technical traders, moving average crossovers are the most common trading signal -- when a “faster” moving average (a lower number of periods) crosses above a “slower” moving average, a buy signal is produced.

    When the slower MA crosses above the faster, a sell signal is produced. While your mileage may vary with crossover signals like this, in my experience they’re best used as confirmation of a potential trade rather than a primary buy or sell indicator.

    Next week, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.

    In the meantime, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.

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    Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.