A Moving Average is an indicator that shows the average value of a security's price over a period of time. When calculating a moving average, a mathematical analysis of the security's average value over a predetermined time period is made. As the security's price changes, its average price moves up or down.

There are five popular types of moving averages: simple (also referred to as arithmetic), exponential, triangular, variable, and weighted. Moving averages can be calculated on any data series including a security's open, high, low, close, volume, or another indicator. A moving average of another moving average is also common. The only significant difference between the various types of moving averages is the weight assigned to the most recent data. Simple moving averages apply equal weight to the prices. Exponential and weighted averages apply more weight to recent prices. Triangular averages apply more weight to prices in the middle of the time period. And variable moving averages change the weighting based on the volatility of prices.

Interpretation:

The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security's closing price and the security's closing price itself.  A sell signal is generated when the security's price falls below its moving average and a buy signal is generated when the security's price rises above its moving average. This type of moving average trading system is not intended to get you in at the exact bottom and out at the exact top.  Rather, it is designed to keep you in line with the security's price trend by buying shortly after the security's price bottoms and selling shortly after it tops.

The critical element in a moving average is the number of time periods used in calculating the average.  When using hindsight, you can always find a moving average that would have been profitable.  The key is to find a moving average that will be consistently profitable.  The most popular moving average is the 39-week (or 200-day) moving average.  This moving average has a good track record in timing the major (long- term) market cycles. The length of a moving average should fit the market cycle you wish to follow:

Example ( Short Term & Long Term)

Following figure shows a 25-day simple moving average of the closing price of Caterpillar.

Since the moving average in this chart is the average price of the security over the last 25 days, it represents the consensus of investor expectations over the last 25 days. If the security's price is above its moving average, it means that investor's current expectations (i.e., the current price) are higher than their average expectations over the last 25 days, and that investors are becoming increasingly bullish on the security. Conversely, if today's price is below its moving average, it shows that current expectations are below average expectations over the last 25 days.

The classic interpretation of a moving average is to use it to observe changes in prices. Investors typically buy when a security's price rises above its moving average and sell when the price falls below its moving average.

"Buy" arrows were drawn on the chart in Figure when Aflac's price rose above its 200-day moving average; "sell" arrows were drawn when Aflac's price fell below its 200-day moving average. (To simplify the chart, I did not label the brief periods where Aflac crossed its moving average for only a few days.)

Traders' remorse

Moving averages often demonstrate traders' remorse. As shown in Figure , it is very common for a security to penetrate its long-term moving average, and then return to its average before continuing on its way.Long-term trends are often isolated using a 200-day moving average. You can also use computer software to automatically determine the optimum number of time periods. Ignoring commissions, higher profits are usually found using shorter moving averages.