Moving Averages

By: Peter McKenna

The following is an excerpt from Peter McKenna's The Event-Trading Phenomenon

If you add together the closing price of the S&P 500 Index over the past 10 trading days and divide the result by 10, you have found the 10-day moving average of the index.  It is called a “moving” average because it moves with the calendar.  The closing price for the 10th day is always dropped and the current day’s closing price is added.  Moving averages are most often calculated for 10-day, 30-day, 50-day, 100-day and 200-day periods.

You can find charts of the moving averages for the major indexes in Investor’s Business Daily, the only daily financial newspaper I know of that provides a 200-day moving average of the indexes.  The index line tracks the daily performance of the index itself.  The moving average line tracks the 200-day moving average, which is the sum of the closing prices of the past 200 days, divide by 200.

The relationship of the index line and the moving average line is what event traders should take note of.  As long as the index line stays above the moving average line, the index, and hence the overall market, is considered to be in a healthy, upward trend.  The reverse is also true.  If the index line falls below the moving average line, the market is thought to be in trouble.  The slope of the moving average line is also important.  A gradual upward slope shows a slowly rising market.  Sudden upward or downward moves shows that something dramatic has happened to change investor sentiment.

It is wise for event traders to get acquainted with the concept of the moving average.  It is good practice to keep a record of the S&P 500 closing prices in a journal.  Average the prices every 10 days and record the average in a way that shows the progression of the average.

Simple Moving Average/Exponential Moving Average

The 10-day moving average discussed above is called a simple moving average.  It is an average of the closing prices of a stock or an index during the last 10 days.  In the calculation of this average, all 10 days are given equal weight.  An exponential moving average, however, gives more weight to recent closing prices.  This is done through a formula that uses a weighting factor.  Most financial web sites and some newspapers will provide both a simple and an exponential moving average for the major indexes, saving the investor the trouble of learning the formula.  This method is considered a more accurate barometer of market direction than a simple moving average.

Moving Average-Convergence-Divergence Indicator (MACD)

The MACD is another moving average used to determine trends.  It measures the difference between three exponential moving averages, called EMAs.  They are a 12-day EMA, a 26-day EMA and a 9-day EMA.  The result is plotted on a chart as follows:

  1. A 12-day EMA is calculated.
  2. A 26-day EMA is calculated.
  3. The 12-day EMA is subtracted from the 26-day EMA.
  4. The result is shown as a solid line.  This is called the MACD line.
  5. The 9-day EMA of the MACD line is calculated.
  6. The result is shown as a dashed line.  This is called the signal line.

When the MACD line crosses and rises above the signal line, the market is going up.  When the MACD line crosses below the signal line, the market is going down.  As the market continues to climb, the gap between the two lines will get wider and wider.  This means upside momentum is building.  The gap between the lines will get wider and wider as the market goes continually down.  This means downward momentum is accelerating.