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Moving averages are used very extensively by trading professionals in stock and commodity markets. The importance of the moving average can often be misunderstood. Many traders and market makers use moving averages to determine support and resistance points as well as changes in the direction of a market or stock.

First, lets back up a bit and define what a moving average is. A moving average is the average price of a stock or commodity for a pre-defined number of periods that changes, or moves, when a new period is added and the oldest period is dropped. For example, if you are using a 14 day moving average you would add up the closing prices for the last 14 days and divide that number by 14. On the 15th day you drop the oldest day and add up the last 14 days and divide by 14 again. Now you have two data points. This continues everyday. Fortunately today we have computers that do all the hard work for us, all we have to do is tell it how many periods we want to use and it's done in an instant.

A period can be defined in days, weeks and months. It can also take the form of minutes if you are day trading. So the question becomes, what is the best period to use? The common periods are 9, 14, 21 and 50, but there are many opinions about this and individual investors may have their own timeframe they use that works best for their system.

So, how do you determine what number of periods to use? One way is to choose an average that provides support to reactions, especially for the first reaction after a trend change.

For example, say a market maks a low, then rallies for 10 days, then pulls back for 5 days before turning higher and taking out the high of the first 10 rally, thereby confirming the birth of a new uptrend. The correct average would be the one that offers support at the 5 day low. An average that is too long would be slow to react and would not provide support at the 5 day low, theyby missing the change in trend. An average that is too short would find the price crossing it two or more times and not useful in providing support trend information.

It is important also, to use short, medium and long term moving averages in your charts to help define support and resistance areas and changes in trend for different time periods.

Author: John C Morgan
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