Problems with the Simple Moving Average

The simple moving average of a security is a basic arithmetic measure of the change in its price over time. This average is calculated by adding up the closing price of a security for each day in a given period and then dividing the sum by the number of days. There is no special weight given to any particular day. The moving average can be calculated in a short- or long-term cycle, and the result is a measure of the average price of a security for that period. Since the formula is so basic, it often fails to give key information on price trends with the security. 

Short-Term vs Long-Term Average

Simple moving average is often used to discover an uptrend in stock pricing. For any given security, an analyst can find a short-term and a long-term moving average. For example, a security's short-term average over the past month may be $4 per share. The long-term average over twelve months may be $3.50 per share. This indicator could show the security is experiencing a short-term lift in prices. The analyst must then decide whether the security will fall back below the average or break a previously imposed price ceiling. Depending on other factors, the result of this analysis could lead an analyst to recommend buying or selling the security. However, used alone, the simple moving average could not show an analyst whether a security is briefly on an uptrend or actually breaking through to a higher ceiling.

Weighted Average vs Simple Average

Perhaps the biggest downside of simple moving average is the way it imposes the same weight to each day in the price cycle being considered. This can be compared to a teacher who uses simple grading as opposed to grading on a trend. If a student performs very well in the first half of a semester and then fails three tests toward the end of a semester, the simple average for this student's grade may still be a "B." However, if the student would like an indication of where his or her grade may head next semester, it would be important to note the way the grade dropped off. Weighting the test scores to give more importance to the end of the semester's grades, the teacher may actually give the student a "C" grade. 

The same model can be used with security price to indicate which direction it will head in the immediate future. For example, over the past twelve months, a security has a simple moving average of $4 per share; however, in the past 10 days, the average is $4.25 per share. If more weight is put on to this past 10 days using an exponential moving average, the average may total out to $4.05 per share or $4.10 per share. Another security also has a twelve-month simple average of $4 per share; however, in the past 10 days, the average is $3.50 per share. In this case, the first security would be experiencing the uptrend. An exponential moving average would show this.

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