Technical Terms: What Are Moving Averages And What Do They Do?

The price of a barrel of oil traded on Monday below its 100-day moving average. A savvy investment individual would find this statement easy to comprehend, but a novice investor could find the concept of a moving average (and what it signifies) confusing.

A moving average is simply a ratio of the average price of a tradeable asset, such as a barrel of oil or a stock, over a period of time. The time frame can range from five days to as much as 200 days or more.

One of the most common moving average ratios is a five-day simple moving average and is derived by adding the five most recent closing prices and dividing the summation by five.

An exponential moving average is similar to a simple moving average, but it places more emphasis on the most recent data — hence the term exponential. The weighting of older data inputs decreases exponential, but never reaches zero.

The exact weight of each data input depends on the number of periods in the moving average. For example, a 20-period time frame applies a 9.52 percent weighting to the most recent price and is calculated as follows: 2/(20+1) = 0.0952, or 9.52 percent.

An exponential moving average with 10 periods assumes an 18.18 percent weight to the most recent price - 2/(10+1) = 0.18181, or 18.18 percent.

They key difference between the two averages is that an exponential moving average has less of a lag and is more sensitive to recent price changes.

Finally, a moving average serves as a trend because it is based on historical prices. In the case of oil dipping below its 100-day moving average, many investors and traders would consider this to be the momentum when the commodity enters into bear territory and further downside is expected.

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