A moving average is simply the average of a number of data points, but it is also the most widely used technical analysis tool. The moving average provides a way to measure the mood of any market. Best of all, they are a easy for the average trader to interpret and use. While I will illustrate moving averages using daily closing stock prices, you should be aware you can take a moving average of any kind of time series data, from the volume of shares traded to the weekly number of people applying for unemployment insurance.
First we will use stock prices and illustrate how to calculate a simple five-day moving average manually. Consider a stock that posted closing prices over the last five days of $12, $11.50, $10.50, $11, and $10. The five-day average is then (12 + 11.5 + 10.5 + 11 + 10) / 5 = $11. The next trading day we get a new closing price, say $9.50, and at the same time we drop out the oldest ($12) reading. The average now moves down to (11.5 + 10.5 + 11 + 10 + 9.5) / 5 = $10.50. Below is an illustration of a simple 5 day moving average using the price chart for eBay (Symbol: EBAY).
So we receive a single number each day that represents the average of the closing prices for the last five trading days. We then plot each of these values over the price chart to form a line. Notice that the moving averages will move with the market, but lag behind the daily price action. On the first day the stock closed at $10 but the average was $11. After the $9.50 close the next day the average moved down to $10.50.
The more days that are used for your moving average, the bigger this lag will become. That is what makes choosing the appropriate time period critical. There may be a lag problem if you use too long a time period. But if you use too short a time frame, the moving average will be too close to the market to be of any use.
So what average should you use? Most traders like to stick with round numbers like 5, 10, 20, 50, and 200 for their moving averages. The 200-day moving average is very popular with investors watching stock indices for long-term trading signals. There is no single right answer, since different time periods are useful for different markets.
When looking for the best moving average to use for a particular asset or index, start with a simple average like 10 or 20 days. Then see if the price bars spend a lot of time either above or below the average. You want to minimize the number of periods of “noise”, where the bars are mixed in with the moving average line.
Once it passes that test, look at where the market breaks above or below the line. You would like to see clean breaks that signal significant price moves (preferably accompanied by higher volume). Finally, look to see if the moving average shows signs of being a good support line in an uptrend or resistance line in a downtrend. If it does not perform well on these tests, readjust the time period and try to find a better time frame.
So how would you use a moving average when trading options?
One basic strategy would be to buy a call option when the market crosses the moving average from below, and to buy a put option when it moves from above to below the moving average line. While a moving average does not predict when the market turns due to its "lagging” nature, signal received are usually quite safe because the market has to be moving in the same general direction for the moving average to breach the line. This has been summed up in trading literature with the phrase “the trend is your friend".
When markets are moving sideways, a moving average won’t do you much good. The moving average will spend a lot of time just above or just below the market, and you will see lots of crossovers. Trading with a moving average during that kind of market often get “whipsawed”. What happens is that you place a trade, only to have the market reverse. Once you close that trade (at a loss) and place another in the opposite direction, the market reverses again. In that situation you would end up with a lot of losses. You need to recognize when the market is in a sideways trend and avoid trading then.
The best moving average uses a time period that reduces the number of trades you need to make, but still gets you in on all those big moves. One way to reduce the “whipsaw” problem is use more than one moving average. Try superimposing moving averages with two different time periods on a price chart. When they cross is your signal to trade.
Below is a chart of the NASDAQ 100 index with both a short-term (20-day in blue) and long-term (200-day in red) simple moving average superimposed on it.
As you can see, the 200–day moving average rarely crosses the price chart. In fact it has done so only a few times in the past 18 months. But notice that most of the signals based on the stock price moving through the 200 day moving average would have been very good trade signals. Now let’s look at where the two different moving averages cross.
The 50 day moving average crosses the 200 day moving average only four times in the past 18 months. The first signal on 4/12/05 signaled almost a 5% drop in the next 2 weeks. The bullish signal of 5/31/05 signaled the beginning of rise in the index that lasted almost a year. The third signal (bearish) in May of 2006 not only would have been your signal close any long positions, it also came just before an almost 10% drop in the index over the next month and a half. The fourth and final signal was received just this week, and it is too early to tell how well this signal anticipates future price movements.
During an uptrend or a downtrend the market moves in a series of peaks and valleys. Often you can find a particular moving average that acts as a good indicator for support or resistance. If a moving average has a history of acting as resistance in a downtrend (or support in an uptrend) then it will also give high-quality trading signals.
One of the main criticisms of the simple moving average is the lag created by using the older data. One way to reduce that lag is by using an average that places more importance on the more recent prices, usually called an exponential, or weighted, moving average. While I won't go into the manual calculations, you should be aware that this kind of average reacts more quickly to turning points and "hugs" the market more.
Moving Averages are a useful tool for understanding the overall direction of a market that are best used in conjunction with other methods of analysis. They are a lagging indicator, so they will not get you out at the very top, nor back in at the very bottom, but they do provide high quality trading signals and are useful as confirming indicators.