Today we are going to cover a very basic, simple moving average method. Before we dive into exactly what a moving average is it is prudent for us to discuss “time series”. Time series are used in a wide variety of fields such as statistics and econometrics and mathematical finance, even weather forecasting. A time series is a sequence of data points that are basically spaced out at even time intervals. A bar chart of the Dow Jones industrial average is an example of a time series. On a daily bar chart each of the bars represents a separate day.

The whole point of analyzing a time series is to be able to extract some type of statistics or characteristics of the data that we can use. In the financial markets, of course, we would like to use this type of data to predict or forecast future price movements. In actuality, what we are doing is we are “anticipating” future price movements. We can call them predictions, perhaps when you anticipate a price movement and that price movement becomes reality. At that point people go back and say, “well it wasn’t necessarily anticipated, I predicted that price move”. We are smart enough to remain humble because we have to understand as always that is it the markets that are in charge…. not us.

So here we have our daily chart and on this chart we have two different moving averages, which are very popular moving averages in the financial markets. One is a 200-day moving average (dark blue line) and the other is a 50-day moving average (light green line). If this were a different type of chart, it could be any financial market and we could use any time frame. Say for instance, we change from daily to a weekly chart of the Dow then the dark blue line would be a 200-week moving average and the light green line would be a 50-week moving average.

We can on our chart that this trend is up and that the prices are staying well above the 200-day moving average. As you can see the 50-day moving average is a lot closer to the prices than the 200-day moving average. This is simply because of the nature of moving averages. The smaller the length of the moving average, the closer it will be to the prices of the market we are analyzing.

Let’s jump into taking a quick look at the moving average and how it’s calculated. The moving average gets its name is because it is an average that moves as the market’s prices change. A certain number of prices are all added together and then we take that sum and divide it by the number of prices we have chosen. In most cases the moving average is based upon the closing price.

In our example, this particular moving average is based upon the last 50-closing prices. They are all added together and then divided by 50. In the case of the 200-day moving average the last 200-of closing prices are all added together and then divided by 200.

Let’s say we wanted to create a simple moving average method to experiment with. We will start off by using our 50-day simple moving average indicator. There are any number of different ways we could enter the market. We could buy at the point when the price goes above the simple moving average (SMA). We could also buy when the price closes above the SMA. Once the price closes above the SMA we can either buy at market on close (MOC) or we can buy on the open of the next day (MOO). Conversely, we could sell short once the price closes below the SMA at market on close (MOC) or we can sell short on the open of the next day (MOO).

Market On Close Example:
If the price closes above the 50-day SMA, then buy at MOC
If the price closes below the 50-day SMA, then sell short at MOC

Market On Open Example:
If the price closes above the 50-day SMA, then buy the next day at MOO
If the price closes below the 50-day SMA, then sell short the next day at MOO

The typical interpretation is that when the price closes above the SMA we can anticipate that the price may move higher. When the price closes below the SMA we can anticipate that the price may move lower. Of course, this does not mean that the price will always move as anticipated. For this reason we have risk controls in place because not every method we use, whether it is a moving average method or any other type of method that is always going to be in sync with the with the market.

So that’s basically it as far as coverage of the simple moving average method. One last method I’d like to discuss is something called the moving average crossover. A crossover works as follows. When the short-term moving average comes from below the long-term moving average and crosses over it the typical interpretation of that is that it’s bullish and that that is an opportunity for us to go long. When the short-term moving average comes from above the long-term moving average and crosses under it the typical interpretation of that is that it’s bearish and that that is an opportunity for us to go short.

Naturally, finding the best parameters for trading using SMA’s and moving average crossovers is the subject of some of research and experimentation on the part of anyone who wants to use them. That concludes our coverage of the simple moving average method which some coverage of two very common moving averages, the 50-day moving average as well as the 200-day moving average.