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Saturday, August 14, 2010

Understanding Stock Moving Average

When talking about the stock market, we often use a simple average, like any Index, to quickly understand the big picture. But the Index is not a perfect representation because it's usually made of only a limited number of large stocks.

When looking at an individual stock, we can use a similar idea, a moving average, to see the bigger picture.

Let us consider a particularly volatile stock. For example it peaked near 200 in March then bottomed under 60 in June and the most recent price is 140.

A simplistic moving average for the above stock (more precisely, the arithmetic mean) is calculated exactly as you would expect. Add all the values together (210 + 70 + 140 = 420) and divide by the number of values (3) = 140. Consider this as a moving average of a series plotted against time.

Is this stock trending higher? Or lower?

Many argue that day-to-day price fluctuations are completely random, and longer periods are required for trends to emerge. If we could smooth the price fluctuations, it might help us see the emerging trend.

However, the market sometimes offers a hint. A moving average reveals the general direction and strength of a stock's price trend over a given period.

When properly used and understood, a moving average is a very powerful tool. It's not complicated, but you should understand how a moving average is created. It will help you understand why you might choose one moving average over another.

It will also help you choose a reasonable time frame to match your investing style.