Simple Arithmetic Moving Averages

What is the simple arithmetic moving average?

A moving average is simply a rolling series of arithmetic averages which acts as a smoothing mechanism to indicate trends in historic data. In financial markets that historic data is most likely to be prices or returns, for example end of day prices or daily returns. A moving average is easy to calculate, which is why it’s so popular.

How do you calculate and use the simple arithmetic moving average?

All you do is find the average of a set of data and for every subsequent period you add the newest data and drop the oldest one. Over time that builds up into a moving average line. It’s used by traders and investors who study price history or charts. The idea is to use them to identify trends or changes in trends as a means of making trading decisions. They are also used as a method for forecasting the next period’s data, whether that be tomorrow's closing price or return.

What are the limitations of using a simple arithmetic moving average to predict market prices?

Although moving averages are heavily used as trend indicators, they are lagging indicators. In other words, they look at past history. Markets are forward looking in that the market price is based on the investor's collective consensus of future prospects. Changes to the consensus resulting from news flows prompt changes to market prices. Moving averages could therefore be viewed as a delayed reaction to changes in market expectations. Using them successfully then, probably needs more than a cursory glance at lines on a graph.