Moving average is one of many technical analysis indicators.
Nowadays, virtually every trading software has it built in and you can add it with a few mouse clicks.
But how does it work, what it means and how can you use for trading? Let's start with mathematical formula.
As the name suggest this indicator is an average (arithmetical) of a few numbers.
Usually, the numbers are stock's daily close prices over a certain period of time.
For example a stock closes at $2 on Monday, $2.
5 on Tuesday and $3.
3 on Wednesday.
In a such case moving average of last three days would be $2.
6.
What happens on Thursday when the stock closes at $4? If we still want to calculate 3-day average we have to ignore price from Monday and add price from Thursday, this way its value would be $3.
27 ((2.
5 + 3.
3 + 4)/3)).
This indicator is called "moving average" precisely because of dropping the oldest value (Monday) and replacing it with the newest (Thursday).
Did you notice how its value changed from $2.
6 on Wednesday to $3.
27 on Thursday? That's the reason why this indicator is useful for traders.
Traders use it mainly as trend trading aid.
There are many ways how this can be done and finding the best for you and market you want to trade requires some work, so let's glance over the main methods: Entering long position when price is above its average and entering short position when the price is below: this is probably the simplest and most popular way of trading it.
If you "listen" to this indicator you will get a lot of small losses and a few big winners.
This is what trend traders do: when they - wrong they exit quickly, when they right - they ride a trend and make a killing.
Watching the slope of the average: when moving average points up - go long, otherwise go short.
This method gives fewer losing trades but losses are bigger.
Go long when short-period moving average is above long, go short otherwise.
Moving average of just a few days follows the price quicker than that of hundreds of days.
Some traders watch for moving averages crossover and enter the position accordingly.
In one sentence: this indicator gives you clear answer where the price has been going, how you use this information is up to you.
When stock market index goes below its long-term moving average some people like to close their stock position and convert to bonds.
Others are more aggressive and switch between long and short quite often.
Finding what works for you and for market of your choice takes a little bit of work, but results are really worth it.