Last update: August 2021

Sometimes price action is messy. Candlesticks go cuckoo and volatility jacks up your charts. I’m not a fan of indicators. There are thousands, and most are redundant rehashes of what we already know.

But I do have a favorite. After price, it is the one I use the most, a trusty friend I rely on time and time again. It’s the moving average, and we’re about to kick off a multi-part series that lays out what it is and exactly how to use it.

Let’s begin.

The Math

Moving averages are the poster child for tinkering taken too far. Do you know how many variations ThinkorSwim offers for this seemingly simple indicator?

24!

The proliferation of what should be a simple indicator is a byproduct of ego and mans’ desire to build a better mousetrap. Sadly, I’ve found many of the variants to be unnecessarily complicated or something that brings a con for every pro.

We’re focusing on the purest form of the moving average – a simple moving average (SMA). The math is easy. Suppose we’re calculating a 5-day moving average based on the closing price of the last week’s trading.

5, 6, 7, 8, 8 (Closing prices for the last five sessions)

To calculate the average, we would add up all five numbers and divide by five.

5 + 6 + 7 + 8 + 8 = 34 ∴ 34 ÷ 5 = 6.8

6.8 would be the starting point for the 5-day simple moving average. Each day a new price is added to the calculation, and the price that is now six days ago is removed. For example, suppose the next day the stock closes at $10. Here would be the new calculation:

6 + 7 + 8 + 8 + 10 = 39 ∴ 39 ÷ 5 = 7.8

Were we to continue this exercise you would notice a few things about how the simple moving average works. Here are 3 Keys of Moving Averages:

1. Price moves first, then the moving average follows.
2. The moving average is a lagging indicator.
3. The moving average clarifies the day-to-day noise or volatility and reflects the essence of the trend.

Time Frames

Moving averages can be measured over any time frame. However, over time a few time frames have become the most popular like the 20-day, 50-day, and 200-day moving averages.

• The 20-day is a reflection of the short-term trend
• The 50-day is a reflection of the intermediate-term trend
• The 200-day is a reflection of the long-term trend

I’ve alluded to the first use of a moving average, but let’s state it explicitly in case you missed it.

Moving averages reflect trend direction. If the moving average is rising, then the trend of that time frame is bullish. If the moving average is falling, then the trend of that time frame is bearish.

Consider the following chart, for instance.

The 20 SMA (red line) is rising, which signals the short-term is UP. The 50 SMA (blue line) is rising, which signals the intermediate-term trend is UP. Finally, the 200-day SMA (green line) is slightly rising, which signals the long-term trend is UP.

Trend Following

Moving averages are known as a trend following indicator. They work great when prices trend but are utterly useless in trading ranges. That means the signals that traders use them for don’t work well when prices are stuck in a range.

We’ll explore this more in future articles, but here’s an example of the moving averages getting no respect. Note how the price slices above and below the SMA again and again and again.

In future articles, we’ll explore how moving averages can help identify momentum and trend reversals. Stay tuned.

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