| Know It Olly

TL:DR – A moving average is a tool used in finance to smooth out stock prices by averaging them over a set period, like 10 or 50 days. This helps identify trends by showing the average direction of the price, making it easier to see if a stock is generally going up, down, or staying the same.

What is a Moving Average?

A moving average is like a tool that helps people understand how a stock’s price is changing over time. Imagine if you wanted to know the average score you got on your math tests over the past few weeks. You would add up all your scores and then divide by the number of tests you took. A moving average does something similar but with stock prices. It helps investors and traders figure out if a stock is generally going up, down, or staying the same.

Why Do We Use Moving Averages?

Moving averages are really important because they help smooth out all the ups and downs in a stock’s price. Stocks can be a bit like a roller coaster, going up one day and down the next. If you only look at each day by itself, it can be hard to see if the stock is actually doing well or not. Moving averages take all these little ups and downs and create a line that shows the overall trend, or the “big picture.”

For example, if the moving average line is going up, it means that, overall, the stock is doing better and getting more valuable. If the line is going down, the stock is losing value. This is super helpful for people who want to decide if they should buy, sell, or keep their stocks.

Different Types of Moving Averages

There are two main types of moving averages that people use: the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

Simple Moving Average (SMA):

A Simple Moving Average is just what it sounds like. It’s the average of a stock’s price over a certain number of days. Let’s say you want to find out the average price of a stock over the last 10 days. You would add up the closing prices for each of those 10 days and then divide that number by 10. The result is your 10-day Simple Moving Average.

Exponential Moving Average (EMA):

The Exponential Moving Average is a little more complicated. It still takes the average of a stock’s price, but it gives more importance to the prices from the most recent days. This makes it react faster to changes in the stock’s price. So if something big happens in the market, the EMA will notice it quicker than the SMA.

How Are Moving Averages Used?

Moving averages are used to help people figure out which way a stock is likely to move. They are especially helpful for seeing trends—whether a stock is generally going up (an uptrend) or down (a downtrend).

Identifying Trends:

Uptrend: If the moving average is sloping upwards, it means the stock is generally getting more expensive, which is usually a good sign. Investors might decide to buy the stock if they see this.
Downtrend: If the moving average is sloping downwards, it means the stock is losing value. This might be a signal for investors to sell the stock before it loses even more value.

Support and Resistance Levels:

Support Level: A support level is like a floor that the stock price doesn’t want to fall below. Sometimes, the moving average line acts as this floor. If the stock price gets close to the moving average and then starts to go up again, this is called a “bounce,” and it might be a good time to buy.
Resistance Level: A resistance level is like a ceiling that the stock price doesn’t want to go above. If the stock price hits the moving average and then starts to fall, this might be a signal that it’s time to sell.

Common Time Periods for Moving Averages

Moving averages can be calculated over different time periods, and each one is useful for different types of trading. Let’s look at the most common timeframes and what they’re used for.

1. 10-Day Moving Average:

This is great for traders who want to make quick decisions based on very recent price changes. It’s ideal for day traders or those who hold stocks for a few days.

2. 20-Day Moving Average:

A bit less sensitive than the 10-day, the 20-day moving average is used by traders who want a clearer picture of short-term trends without too much noise.

3. 50-Day Moving Average:

One of the most popular timeframes, it balances current trends with avoiding short-term fluctuations. It’s useful for identifying trends that might last.

4. 100-Day Moving Average:

This is a medium- to long-term indicator, giving a broader view of the market or a stock’s direction over a few months.

5. 200-Day Moving Average:

The 200-day moving average is key for long-term investors. It looks at around 10 months of data, helping to spot long-term trends.

How Do Different People Use Moving Averages?

Different people use moving averages in different ways depending on what they’re trying to do.

Traders:

Traders are people who buy and sell stocks quickly, sometimes even within the same day. They use moving averages that cover shorter time periods, like 20 days or even just a few minutes, to make fast decisions about when to buy or sell a stock.

Long-Term Investors:

Long-term investors are people who buy stocks and keep them for a long time, maybe even years. They use moving averages that cover longer time periods, like 200 days. These longer moving averages help them see the big picture and decide whether a stock is a good long-term investment.

Challenges and Limitations of Moving Averages

Even though moving averages are really helpful, they’re not perfect. Here are a few challenges and limitations that you should know about:

Lagging Indicator:

Moving averages are what’s called a “lagging indicator,” which means they are based on past prices. Because of this, they don’t react right away to sudden changes in the market. For example, if a stock’s price drops suddenly, the moving average won’t show this right away because it’s still averaging in the higher prices from before the drop.

Whipsaws:

A whipsaw happens when the stock price crosses the moving average line, making it look like the trend is changing, but then it quickly reverses direction. This can trick investors into buying or selling at the wrong time. Shorter moving averages, like a 20-day SMA, are more likely to produce whipsaws because they react faster to price changes.

Beyond the Basics: Other Uses of Moving Averages

Moving averages aren’t just for stocks. They can also be used in other financial markets, like bonds or commodities, which are things like gold or oil.

In Other Markets:

Just like with stocks, moving averages can help traders and investors in other markets figure out if the price of something is going up or down. This can help them make decisions about when to buy or sell.

As Part of Other Indicators:

Moving averages are also used in combination with other tools that traders use to make decisions. For example, the MACD (Moving Average Convergence Divergence) is a popular indicator that uses two different moving averages to show whether a stock is gaining or losing momentum. Another tool is the Bollinger Bands, which use a moving average to show when a stock might be overbought (too expensive) or oversold (too cheap).

In Risk Management:

Traders also use moving averages to manage risk. For example, they might set a “stop-loss order” at a certain level below the moving average. This means if the stock price drops to that level, the stock will automatically be sold to prevent bigger losses.

How Are Financial Institutions and Banks Affected by Moving Averages?

Big financial institutions like banks use moving averages on a much larger scale than individual traders or investors.

In Trading Strategies:

These institutions often use moving averages as part of their trading strategies. Because they trade huge amounts of stocks, their actions can actually influence the overall market. For example, if a lot of banks decide to buy a stock because its moving average is going up, this can push the stock price even higher.

Influence on the Market:

When many big institutions use the same moving averages, like the 200-day SMA, it can create strong support and resistance levels. This is because so many traders are watching the same numbers and making decisions based on them. When the price hits these levels, you can often see big changes in the stock’s price as lots of people either buy or sell at the same time.

Conclusion: Why Moving Averages Matter

Moving averages are a powerful tool that help traders and investors see the big picture of a stock’s price movement. They make it easier to figure out whether a stock is going up, down, or just staying the same. While they’re not perfect and have some limitations, like being slow to react to sudden changes, moving averages are still one of the most important tools in technical analysis. Whether you’re a quick trader or a long-term investor, understanding moving averages can help you make better decisions in the stock market.