70 years after FDR signed his Revenue Act into law. Known by its well-heeled opponents as the Wealth Tax Act, the law goosed taxes for the wealthy and big business and got the president labeled a “traitor to his class” and a communist.

Good Tuesday, Sleuths, and welcome to the second installment of our regular feature on technical analysis and charting tools.

It is my distinct pleasure (if not mundane responsibility) to introduce hail-fellow-well-met, Mr. Mark Bail. Mr. Bail is a former attorney and registered investment advisor and the resident technical guru here at Agora Financial. (And no, in this case “guru” is not too strong a word.) We’re pleased as punch Mark has taken the reins at the MST Trader Alert and that he’s agreed — by signing in his own blood, with confirming secret handshakes slated for later today — to share some of his considerable knowledge on the subject with us. He begins this part of our journey with the truth about a very moving subject, indeed.

So without further ado…Mr. Mark Bail. Oh, Mark…

Thanks, Carl, for what can only be described as an “introduction”.

Carl is right: My name is Mark Bail, and I’m the editor of the MST Trader Alert, an options trading newsletter. In the MST Trader Alert, I employ a combination of technical analysis tools to give traders the best chance to achieve short-term profits in the options market.

Because my background is rooted in technical analysis, my friend Carl asked me to contribute to Penny Sleuth every other Tuesday — Technical Tuesday — by offering my perspective on different technical indicators and other aspects of technical analysis, and he asked me to begin by discussing moving averages. So, let’s begin, shall we?

Moving averages are one of the most commonly used technical indicators in trading and investing. And they are used in a variety of ways. There are several different types of moving averages, different lengths used in moving averages, and different ways to use moving averages. Since the subject of moving averages covers so much ground, I thought it best to break this up into two parts. Today, I’ll discuss the different types of moving averages, how each one is constructed, and the strengths and weaknesses of each. Next time, I’ll delve into some of the ways moving averages are used in trading and investing.

Moving Averages: What They Are

I think when examining any technical indicator, it’s always a good idea to have a basic understanding of what that indicator purports to reflect. So, let’s begin our study of moving averages by simply stating what they are and the purpose for creating them.

In its basic form, a moving average is simply a smoothing of the seemingly random fluctuations of the prices of a stock, index, futures contract, or any other security for that matter. A security’s prices may often appear to be nothing more than a haphazard series of numbers, with seemingly no connection between one price and the numbers that immediately precede or succeed it. In trading and investing, it’s helpful to place that string of numbers into a discernable pattern from which you can formulate opinions and make more effective decisions.

Averaging prices within a selected time frame enables you to put the trading activity of a security into a larger context that can provide you with greater meaning. And that meaning is a trend. You see, a moving average — any kind of moving average — provides the trader or investor information regarding where a security has come from over a defined period of time — and where it is may be headed. Oh, and one more thing — a moving average alerts the trader or investor when that trend has ended.

Moving averages can be used in any time frame — from one minute to several months. Actually, the number of choices of timeframes is limited only by your imagination and the software you’re using. However, for practical purposes, one minute is the shortest time frame I’ve used — for day trading scalping purposes. And a one month time frame is the longest time period I’ve employed — to uncover very long-term market patterns and to aid in constructing long-term technical timing models.

Moving Averages: The Three Types

There are three basic types of moving averages — simple, weighted, and exponential. All three are constructed by summing up the prices of a security within a predetermined time period and crunching those numbers into a mathematical formula. Now, before you start scratching your head and your eyes glaze over, keep two things in mind. First, the equations are not that difficult. Second — and most importantly — there are numerous trading software packages that take care of the number crunching for you. Some are even free on the internet. All you have to do is select the type of moving average you want to use, the time frame you want to use it in, and the number of periods of prices you want the moving average to cover. The computer does the rest.

When considering how to use moving averages in your trading or investing, it’s important to keep in mind what each type of moving average represents and the information you can glean from the moving average you are employing. So, let’s begin by taking a look at the three different types of moving averages.

The most commonly used moving average — and the easiest to understand — is the simple moving average. The simple moving average is constructed by adding up a series of prices over a selected period of time and dividing them by the number of periods you selected. Let me use an example to put this into English.

Let’s say you want to create a 50-day simple moving average of a stock. I’ll use Videsh Sanchar Nigam (NYSE: TCL) for my example. VSL is a stock that was exited two weeks ago by subscribers of Penny Stock Fortunes — at a much higher price — thanks to Carl’s timely recommendation and his reliance upon moving averages. Now, if you’re going to construct a 50-day simple moving average of VSL, here’s what you do. Go back and add up VSL’s closing prices over the past 50 days. Then divide the total you arrive at by 50. The number you end up with is the average of VSL’s closing prices over the past 50 days — or where its current 50-day moving average is located.

Like I said, you don’t need to be a math person. Nearly all trading software programs do this for you. But the important point to keep in mind is that, in our VSL example above, the moving average changes every day. As VSL establishes a new closing price that price is added to the calculation while the closing price from 51 trading days ago is dropped.

Simple moving averages are the type most commonly used by traders and investors. They are the easiest to understand and the simplest to calculate — hence, its name. Simple moving averages are available in virtually every trading software package. And just the fact that they are so widely followed makes them valuable — since everyone looks at them, they take on a special significance — or at least seem to.

One problem with a simple moving average is that, because the price data is equally averaged over the selected time period, the oldest piece of data has as much influence over the current value of the moving average as the most recent price. Why can this be problematic? Quite simply, the older data dilutes the impact of the newer data. Thus, by definition, the simple moving average cannot react quickly to sudden price changes — or changes in a security’s overall price direction.

The weighted moving average was created in an attempt to overcome this problem. The concept behind the weighted moving average is to place a greater emphasis on more recent price data. A commonly used method for constructing a weighted moving average is to multiply the price data by differing values, based on the age of the data. Typically, the oldest price data contained in a weighted moving average is multiplied by a factor of one, the next oldest data by a factor of two, and so forth all the way up to the most recent price.

Let’s use the above example of VSL to see how a 50-day weighted moving average would be constructed. The price at which VSL closed 50 trading days ago would be multiplied by one. Then, VSL’s closing price from 49 days ago would be multiplied by two, the closing price from 48 days ago would be multiplied by three, and so forth — all the way up to VSL’s last closing price which would be multiplied by 50.

Once all the price data has been multiplied by the assigned factor, the numbers are totaled up and divided by the number of periods — or pieces of data — being used. So, in our example with VSL, the 50 prices — once multiplied — would be totaled up and divided by 50. The remaining number — or quotient for the mathematically minded — represents the current value of VSL’s 50-day weighted moving average. Since a weighted moving average is — by definition — more responsive to recent price movements than is a simple moving average, the weighted average would more closely track VSL’s most recent price movements.

So, if a weighted moving average is more sensitive to recent price changes than its simple counterpart, why not use it? Because — as with most aspects of trading and investing — there is a trade-off. Sure, the added sensitivity of a weighted moving average puts you in tune with current price fluctuations. But you don’t want a moving average to be too sensitive. After all, the purpose of a moving average is to smooth out short-term price fluctuations, in order to filter out any aberrant moves in a security and offer you a clearer picture of the current trend. Weighting the most recent data too heavily could defeat the entire purpose of constructing a moving average and render it meaningless.

And if you thought the simple moving average calculation would require you to dust off your old math skills, the weighted moving average could truly strain those long forgotten mathematical drills. Again, keep in mind that some software trading packages include weighted moving averages and will automatically — and painlessly, I promise — perform all the calculations for you. However, because, in the prehistoric days before high-speed computers, people had to perform these calculations by hand, the complexity of the weighted moving average kept it from developing the vast following that simple moving averages have attracted. So, if you want to use the weighted moving average in your trading or investing, you’ll have to be selective in the software package you use.

Moving Averages: The Exponential Moving Average

The third type of moving average is the exponential moving average. Now, before its name causes you to run for the hills, consider this. An exponential moving average is simply a compromise between its simple and weighted cousins. The exponential moving average was developed as a way to capture the responsiveness and sensitivity to trend change that a weighted moving average furnishes while simultaneously capturing the smoothing effect of the simple moving average and sidestepping the difficulties encountered with the weighted moving average — namely, whipsaw action and a lack of clarity in discerning a security’s price trend.

Now, I need to issue a warning here. If you thought calculating a weighted moving average severely tested your mathematical skills, trying to crunch the numbers for an exponential moving average will really send you for a loop.

Fortunately, in the 21st century, we have computers. And thanks to computers, we need not be burdened by the daunting task of constructing an exponential moving average. Computers will not only calculate an exponential moving average, but plot it on a chart for you -– in the blink of an eye. So, you don’t have to know how an exponential moving average is put together, just how to use it. In fact, I know of NO ONE who calculates and plots an exponential moving average by hand. However, if you’re dying to figure one out for yourself — although I’m not sure why you would — here’s how you do it:

Begin by constructing a simple moving average. Next, ascertain the exponential moving average percentage. The percentage is arrived at by dividing the number two by a number that is one greater than the number of periods in your moving average. So if, for example, you were constructing a 9-day exponential moving average, you would divide two by ten. The resulting percentage — 20% in this case — is then multiplied by the price. Then — still with me? — the product of that equation is added to the prior period’s exponential moving average multiplied by one minus the exponential moving average percentage.

Whew! You may not want to try this at home or have any sharp objects nearby if you do. The significant point to remember about an exponential moving average is the more recent the price, the greater the percentage used as a factor — and the greater the impact of the newer price on the current exponential moving average. As that price recedes further into the past, that factor will shrink and that price’s impact will diminish.

As you can see, the concept behind the exponential moving average is similar to the weighted one. However, by using a percentage instead of a whole number, the influence of the more recent prices is somewhat muted so that they don’t overwhelm the prices from the more distant past.

Many computer trading programs include exponential moving averages in their offering of technical indicators. And while the exponential moving average is a bear to construct and plot, it’s no more difficult to use than a simple moving average — so long as your computer is doing all the mathematical heavy lifting. Just remember that an exponential moving average tries to find a balance between the simple and weighted versions. An exponential moving average attempts to combine the sensitivity to price changes offered by a weighted moving average with the directional clarity of a simple moving average.

So, which is the superior type of moving average — simple, weighted, or exponential? There really is no one correct answer. As I mentioned earlier, each has its strengths and weaknesses. If you are going to use moving averages in your trading or investing, it behooves you to know what they are. Each type of moving average — like any technical indicator — is more effective when used for what it has been created to depict. So, when selecting one or more moving averages to assist you in your trading or investment decisions, give some thought to the purpose you have in mind for them. And in my next article, I’ll discuss some of the ways that moving averages are used — both for entering and exiting trades and for more generalized market analysis.

Mark Bail
August 30, 2005

Moving Averages: Technical Tuesday with Mark Bail was originally featured in the Penny Sleuth.