A moving average is an indicator in technical analysis that smooths out price data by creating a constantly updated average price over a specific number of past periods.
Understanding moving averages
Elephants use moving averages to identify the direction of a market trend. The indicator calculates the mean price of an asset over a set timeframe, which can be measured in minutes, days, weeks, or months. By plotting this average on a price chart, the resulting line filters out random short-term price fluctuations. This makes it easier to observe the overall direction of the market.
There are two primary types of moving averages. The simple moving average is calculated by taking the arithmetic mean of a given set of prices over a specific number of periods. The exponential moving average uses a similar calculation, but it applies more mathematical weight to the most recent prices. This weighting causes the exponential moving average to react more quickly to recent price changes than the simple moving average.
A moving average is a lagging indicator. It is based entirely on historical data and does not predict future price movements. Instead, it confirms existing trends. The length of the chosen period dictates the amount of lag. A short-term moving average tracks close to the current price and reacts quickly to changes. A long-term moving average has more lag and reacts slowly, but it removes more daily market noise.
Traders often place multiple moving averages on a single chart. A common method is to monitor the price chart for a crossover event. A crossover occurs when a short-term moving average crosses above or below a long-term moving average. If a 50-day moving average crosses above a 200-day moving average, traders interpret this as a signal that the asset is entering an upward trend.
Example
Imagine a market where traders buy and sell shares in an agricultural company that produces specialized bulk feed for African savanna elephants. An Elephant looking to invest wants to analyze the daily closing price of this stock over the past year to determine the general trend. The daily price jumps up and down based on short-term factors like regional weather patterns or changes in local transport costs.
To filter out these daily fluctuations, the investor calculates a 50-day simple moving average. By adding the closing prices of the feed stock for the last 50 days and dividing that total by 50, the investor plots a single point on the chart. As each new trading day concludes, the oldest price drops out of the calculation and the newest price is added. The resulting line on the chart shows a steady upward slope. This indicates to the Elephant that the long-term trend for the company is positive despite the short-term price spikes and dips.