This week's question:
DATE: June 29, 2015
Can you explain the concept of a moving average?
When analyzing stock charts, many investors consider changes in stock relative to some moving average when deciding whether to make a bullish or bearish trade. For example, if the closing prices of XYZ were $51, $52, and $53, then to calculate a simple 3-day average of these prices one would add the three closing prices together and then divide by three -- the total number of days. This calculation will yield a value of $52, which is the 3-day average of XYZ's closing stock price for the last three days.
Now, let's consider how a 3-day average becomes a 3-day moving average. Assume that on day four XYZ stock closes at $54. To calculate an average of these last three closing prices, one would now add $52, $53 and $54 and then divide by three - the total number of days. This calculation will yield a value of $53, which is the new 3-day average of XYZ. Notice that the 3-day average has moved from $52 to $53. Many investors use other time periods such as 20-day, 50-day and 200-day moving averages.
Keep in mind that there is no "right" moving average to use. Traders who prefer shorter-term trades tend to use shorter moving averages, but the choice of which average to use is more of an art and not an exact science. To learn more about the concept of moving averages, view this segment of "Ask the Institute"