Using simple moving averages

The most basic type of moving average is the simple moving average. It's also the easiest to calculate and the most common — so common, in fact, that the word "simple" is often left off when a simple moving average is displayed on a chart. Look at Figure 11-4, where a five-day simple moving average is calculated by using the closing prices from five previous days. It can't be much easier: The five closing prices are added up and divided by five. If you keep the number of closing prices in your simple moving averages low, you can easily work them out with a calculator.

The five-day simple moving average in Figure 11-4 comes out at 114.20, and the closing price on the fifth day is 113.87. Some technical analysts would say that indicates a downtrend, because the close on the final day is lower than the moving average. That can be very useful information if you're working on a short-term trade.

Figure 11-3:

A chart with a five-day moving average on it.

Figure 11-3:

A chart with a five-day moving average on it.

Close

Figure 11-4:

A quick calculation of a five-day moving average.

Total

Total/5

114.70 114.73 114.14 113.56 113.87

571.00

114.20

siH?

But if you've got a longer term trade in mind, it wouldn't make much sense to fret over the fact that a closing price dipped below a five-day moving average. There just aren't enough data points (closing prices, in this case) involved — a relatively minor change in a closing price can have a sizable impact on the average. A moving average calculated over a longer period of time (with many more closing prices) — say, 100 days or more — is less likely to reveal any closing prices that cross the average.

The longer your time horizon for a trade (or even an investment), the longer the moving average you need.

Figures 11-5a and 11-5b contain the same pricing data, but Figure 11-5a has a 5-day moving average, while Figure 11-5b uses a 20-day moving average. Notice the extreme differences in trends between the two charts.

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