Both novice and seasoned traders alike should, before trading in the markets, have a complete understanding of moving averages. There are three important indicators that fall under the category of moving averages: simple, weighted or exponential, and linear. Here we focus on simple moving averages.
 
But before we go any further, we must say a word or two about trendlines. Securities move in upward, downward and sideways, or horizontal, directions. These directions are called trendlines. Trendlines tend to move in their respective directions for long periods of time. The major trendline changes have caused the bull and the bear markets that we have seen over the years.

To better understand the trendline, technicians in the late 1930’s looked at pricing data over a set period of time (for example, 10-day, 50-day or 200-day). They discovered that this helps one to understand better the short-term trends of the more long-term trendline. Many market technicians today will start with the favorite of all simple moving averages, the 50-day moving average.

To do the mathematics for a 50-day moving average, simply add the opening or closing prices of the last 50 days of the security you are following. Then divide by 50 to obtain the security's average price over the last 50 trading days. Then plot this number on a chart, and then connect the dots to develop a moving average line. The following day, the technician will take off the first day of the equation and add the present day’s data, and repeat the addition and division process.

The longer the moving average, the more likely it will suffer from what we refer to as "the tail tending to wag the dog". Simply put, this means that the effects surrounding the company six months to a year ago have no real effect on the condition of the company today.





In the above chart of Nortel Networks stock, you can see that in the later part of the summer of 2000, the stock price was trading above the 50-day simple moving average. With the sharp sell-off in the first week of September, the stock price declined below this indicator. This movement was an early indication to investors that they should be thinking about reducing their positions in the telecom giant.

by Investopedia Staff, (Contact Author | Biography)

Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.