Moving averages
Smoothing the daily zigzags into one calm line, so you can see the trend.
Smoothing out the wiggles
Price zigzags every day. Up a little, down a little. It can be hard to tell if it's really going anywhere. A smooths the zigzags into one calm line.
Work one out yourself
The most basic kind is the , or SMA. Here are five days of made-up closing prices for a video game company:
- Monday: $10
- Tuesday: $11
- Wednesday: $12
- Thursday: $13
- Friday: $14
A 3-day SMA on Wednesday adds the last 3 closes and divides by 3: (10 + 11 + 12) ÷ 3 = $11.
On Thursday, Monday drops out and Thursday joins: (11 + 12 + 13) ÷ 3 = $12.
On Friday: (12 + 13 + 14) ÷ 3 = $13.
See why it's called "moving"? The 3-day window slides forward one day at a time. The oldest day falls off the back and the newest day climbs on the front, like kids moving along a lunch line.
What it looks like
In an uptrend, the average sits under the candles and climbs with them. When price dips, it often comes back toward the line, then carries on. In a downtrend, the line sits above the candles and slopes down. When the line is flat and price keeps crossing it, there's no clear trend.
A faster version: the EMA
The , or EMA, cares more about the newest prices. For a 3-day EMA, the newest price counts for half of the answer.
Say price was $12 for three days in a row, so both averages are $12. Today it jumps to $18.
- SMA: (12 + 12 + 18) ÷ 3 = $14
- EMA: it moves half the way from 12 to 18: 12 + (18 - 12) ÷ 2 = $15
The EMA jumped further, so it turns faster when price changes direction. The cost: it also gets fooled more often by quick moves that don't last.
Popular settings
The number of days is called the length. Bigger numbers make smoother, slower lines.
- 20-day: the short-term trend (about one month of trading days).
- 50-day: the medium trend.
- 200-day: the big, long-term trend. Lots of investors check whether price is above or below it.
How traders use it
- Direction: the line pointing up with price above it suggests an uptrend.
- A moving floor or ceiling: in a trend, pullbacks often pause near a popular average, a bit like support and resistance that moves.
- A filter: some traders only look for buys when price is above the 200-day average, and only look for sells when it's below.
Where it fails
In a sideways market, price crosses back and forth over the line again and again, and the line goes flat. It's like asking which way a puppy is walking when it's just running in circles. Moving averages work best when there's a real trend, and they always turn after price does.
Remember
- A moving average is the average close of the last few days, updated every day.
- SMA treats every day the same. EMA counts recent days more, so it turns faster.
- Common lengths are 20, 50 and 200 days.
- It's helpful in trends and confusing in sideways markets.
Check yourself
1. The last three closes were $6, $8 and $10. What's the 3-day SMA?
2. Why is it called a 'moving' average?
3. How is an EMA different from an SMA?
4. When do moving averages work worst?
Next lesson: Moving average crossovers
Money Tree School is education, not financial advice. Examples use made-up or historical numbers to show how things work; they are not recommendations to buy or sell anything. Markets can lose money.