What It Is:
The moving average is a popular technical indicator which investors use to analyze price trends. It is simply a security's average closing price over the last specified number of days.
How It Works/Example:
Some of the most popular moving averages are the 50-day moving average, the 100-day moving average, the 150-day moving average, and the 200-day moving average. The shorter the amound of time covered by the moving average, the shorter the time lag between the signal and the market's reaction.
You can calculate the moving average for any amount of time. To do so, just pick an amount of time to analyze (we'll use 30 days for this example), and take the average of the security's closing price over the last (30) days [(Day 1 + Day 2 + Day 3 + ... + Day 29 + Day 30)/30].
On the surface, it seems as though the higher the moving average goes, the more bullish the market is (and the lower it goes, the more bearish). In practice, however, the reverse is true. Extremely high readings are a warning that the market may soon reverse to the downside. High readings reveal that traders are far too optimistic. When this occurs, fresh new buyers are often few and far between. Meanwhile, very low readings signify the reverse; the bears are in the ascendancy and a bottom is near. The shorter the moving average, the sooner you'll see a change in the market.
Why It Matters:
The moving average is perceived to be the dividing line between a stock that is technically healthy and one that is not. Furthermore, the percentage of stocks above the moving average helps determine the overall health of the market.
Many market traders also use moving averages to determine profitable entry and exit points into specific securities.