I have designed over a dozen analytical stock market software systems for other customers. These individuals generally come from a strong trading background and most often were senior analysts or advisers at a major financial firm. These people have often sent their lifetime studying the markets as well as analytical systems and theories concerning market trends. In almost all cases the systems these individuals want to build is based on the moving average. Time and again I have seen people test theory after theory only to return to using moving rates as their primary analytical tool.
The moving average is not as glamorous as many of the new indicators and specialized prices that mathematicians around the globe are clamoring to create however the moving average you can be sure is still one of the most important indicators you can use. After all, is not past performance the best indicator of future success?
Before we delve too far into an argument supporting the use of the moving average a bit of discussion regarding a description of how the indicator works is necessary. A moving average is simply that, an average of the price of a stock over a set period of time. The benefit of using an average of the prices rather than the actual prices is the smoothing factor the average calculation incorporated into the result. By averaging the prices the impression of unusual price spikes or sudden drops are diminished and what emerges is a more stable or less volatile trend of a stock price's history.
The smoothing benefit of the average has more of an impact over longer periods of time as should be expected. The more data points that are averaged then the greater the weight of the most common price trends. So longer period rates a popular one being 200 days for instance tend to result in much smoother lines than shorter rates. In a sense the longer term rates can be seen as representing a company's long term potential, based on their historical performance and short term rates their daily or weekly trends.
The study of comparing short term moving rates against long term moving averages is probably the most common approach to using the moving average indicator. In fact one of the most popular traditional indicators the MACD (Moving Average Convergence / Divergence) is based on comparisons of short term versus long term moving averages. There are some distinctions between the calculation of the MACD and comparing short term versus long term moving averages however the principle is essentially the same. The difficult part is interpreting what the averages tell you about the stock's performance. Essentially the question is always: Does a short term average cross over a long term line signal a new break out for the stock or will the short term trend fall back in line with the longer term trend? It's not fool proof, you still have to make your own assessments, but the indicator can help you.
Traditionally most analysis of short term versus long term averages considers crosses, where the short term average line crosses over the long term line to most often indicate a new future trend of a stock. In other words, meaning that the longer term average will follow the direction of the shorter term moving average. In reality however this is not always the case. Often short term rates will cross the long term average only to fall back into line with the long term trend. Only you can determine which average indicates the true direction the stock price will take. At this point, often supporting information such as news or quarterly financial releases are used to assist in determining if the short term moving average trend is purely a market driven change or if it reflects a basis for the increased value of the company.
There are some analysts that not only focus on short term versus long term crosses of the moving average but that also take the "steepness" of the cross into consideration. Steep or sharp dramatic crosses in this case are often seen as being strong market direction indicators signaling a future change in the price trend. If you test this with a real chart at stockrageous and select the short term 20 over the long term 200 average which is the traditional standard for short versus long term average cross analysis in a five year chart you will note the impact of steep crosses in almost any stock.
There are some issues with moving rates; most often critics cite the lack of sensitivity to the range of the markets because the average ignores the open, high and the low of each interval. This is especially evident in more volatile stocks which can be difficult to assess when neglecting the volatility of the instrument. Other factors such as breaking news also can not be accounted for in any technical analysis. However the effectiveness of the moving average as an indicator is evident by its sheer sustainability, it was one of the earliest methods of analysis and remains as a key indicator for stock analysts around the globe. Is past performance the best indicator of future success? You decide!