The daily noise of information from the stock market can make investors deaf to a broader trend in stock prices, especially when the stock market is volatile.
The daily peaks and valleys can make it hard to determine what is actually happening – is a stock trending up or trending down?
For stock traders this is a very important question, however for long-term investors the direction of a trend becomes important when they want to buy or sell.
Trends are hard to determine by looking at price information. What really makes the point is a graph of prices over a selected period. This view lets you determine a trend.
A trend is the general direction a stock's price is moving. It does not guarantee it will continue in a certain direction. Tomorrow, the stock could collapse or skyrocket.
What a trend does tell investors in the stock market is which direction a stock has moved over a selected period – say the last three months.
Here's where the daily noise becomes a problem. If you look just at the price, you may see a graph that looks like a mountain range, especially for highly traded stocks or stock indexes.
What investors need is a way to smooth out all those highs and lows so you can see the trend. One way to do that is to use moving averages of the prices to gain a sense of direction
A moving average is simply a stock's average closing price over a selected number of days. You compute this each day and add that data point to the graph. For example, if you wanted to look at a 50-day moving average of a stock's price, you would add up the previous 50 days worth of prices and divide the sum by 50.
Say on Monday at the close of trading, the total of 50 previous day's worth of closing prices equaled 1,750. You would divide that sum by 50 and you would get $35. On Tuesday, the stock closed at $38 per share. You would take add that price to the previous total and them subtract the first day's closing price.
Your new total would represent the most recent 50 days of the stocks price, which includes Tuesday's price, but eliminates the oldest price from the equation. You would then divide that total by 50 for the next 50-day moving average.
This gives you another data point to add to the chart. What your chart looks like is quite a contrast to a chart of just the stock's closing price. Rather than the sharp peaks and valleys, the 50-day moving average chart looks more like rolling hills.
This makes it easier to see if over time (50 days in this case) the stock is trending up or down.
A moving average chart – also known as a simple moving average - is very helpful in getting a clearer picture of the price trend.
However, a simple moving average chart treats each data point equally. In our example above, the day one price is treated the same as the day 50 price. This reduces the ability of stock investors to quickly spot changes in price trends, which may be signals to buy or sell.
A solution to that problem is to use an exponential moving average. An exponential moving average follows the same basic formula as a simple moving average.
The difference is each data point is weighted with more weight given to the most recent data points and less weight given to the oldest data. Since more recent data counts more, the exponential moving average reacts more quickly to price changes.
While this is a good thing, it can also send false signals either up or down and these false signals may indicate a change when only a few days worth of data is out of the normal trading range. This can happen for a number of reasons that may have nothing to do with the stock's real price trend.
To help stock investors with this problem, many use both a simple moving average and an exponential moving average. The simple moving average can serve as a kind of reality check on the exponential moving average.
Fortunately, investors in the stock market have ready access to these moving averages through a number of Web sites. Most will chart both simple and exponential moving averages for many different periods. Shorter periods are more important to traders, while longer periods are more helpful to long-term investors.
Try Yahoo Finance for an excellent graphic representation of these two tools, but remember, no single tool is the magic wand that by itself will tell you whether to buy or sell. However, moving averages are very helpful in reducing the noise and clearing the air around stock prices and trends.