Moving Average is a technical indicator and is used to identify the trend in price movements. The prices of a security are averaged over a period of time and the averages keep on moving with the addition of each new day's price. Moving average could be calculated for any period of your choice depending on your requirement and this is depicted by a trend line.
As for example, if you are looking at a 9 day moving average, you will add the first nine days' closing prices (day 1 - day 9) and divide it by nine (no. of days). That will give you the first point of the Moving Average line. The second point is calculated by adding the closing prices of 2nd to 10th day and dividing it by nine. The process will continue with each new day's price being added to the calculation while the foremost day's price being removed from the calculation. This process will smooth out the day to day price movements of the share and provide the general trend of the price movement.
Longer the period of the moving average the more smoother the price movement is and each new day's price being added would have a lesser impact on the trend. As such, the extreme ups and downs in the price of a share are smoothed out leaving the general trend. If you are interested in the longer term price trend of a share you can select a longer time period like 100 days. On the other hand if your concern is short term price movement you could look at, say, a 15 day moving average.
The above explained Moving Average is called an Arithmetic Moving Average. Another form of moving average is Exponential Moving Average and is calculated by adding a certain percentage of yesterday's moving average to a percentage of the today's closing price. This way you can place more value on the current price than the past data.
Signals from Moving Average
When you look at this graphically, if the price is below the Moving Average line, it is an indication of bearish behavior for the length of the trend and vice versa. Further, if the price is moving from above the Moving Average to below it then it is a bearish indication of the price trend for the time being considered and vice versa. It is important to note that this is a lagging indicator, meaning it will only signal the trend after it has actually starter and as such is a conformational tool.
Another way to generate signals from the Moving Average is to draw two moving averages with two time periods: one for a longer period than the other. Then look for crossover points to help identify periods of significant price changes. Let's look at this graphically.
When a shorter term moving average (18 day Moving Average) crosses from below to above a longer period moving average (50 day Moving Average) it is a bullish signal. That is the trend will be upward and gives a BUY signal. On the other hand, if a shorter term Moving Average crosses down from above a longer term moving average it is a bearish signal and the trend will move downward. This is a SELL signal.
It is considered that the longer the Moving Average (i.e. longer the period) is the more reliable the signals will be and shorter the Moving Average is there will be more false signals or whipsaws. We will also remind you to consider other factors surrounding the company before taking the final BUY or SELL decision.