When one looks at the price action of the market, it is very difficult to establish its trend because of the jagged pattern of the price during a week or month. One of the most used techniques for smoothing the price action of stocks is moving averages. A moving average is a way of averaging the price. The outcome derived -- a smooth line-- provides information on the direction of the market.
Moving averages tend to lag the action of the market. This is the "price" that investors have to pay for the smoothing effect of the moving average. The use of moving averages is twofold. The first important use is as a visual aid for determining the trend of the Market.
The second important use of a moving average comes into play when the actual value of the market falls below the value of the moving average.
They are three types of moving averages:
Simple moving average
Weighted moving average
Exponential moving average
Simple moving average:
This is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation.
Weighted Moving Average
The weighted moving average is a weighted average of the last n prices, where the weighting decreases by 1 with each previous price.
Exponential Moving Average:
Exponential moving averages are recommended as the most reliable of the basic moving average types. They provide an element of weighting, with each preceding day given progressively less weighting. Exponential smoothing avoids the problem encountered with simple moving averages, where the average has a tendency to "bark twice": once at the start of the moving average period and again in the opposite direction, at the end of the period. Exponential moving average slope is also easier to determine: the slope is always down when price closes below the moving average and always up when price is above.