Moving averages come from statistical analysis. Their most basic function is to create a series of average values of different subsets of the full data set. A natural complement to any time series interpretation, a moving average can smooth out the noise of random outliers and emphasize long-term trends. Technical analysts and stock market traders use moving averages in an enormous number of tools, many of which would not be possible without their application. Few indicators have been as reliable.
The prices of securities and values of indexes are volatile and unpredictable, forcing traders to look for any advantage that enables them to reduce risk and increase the likelihood of profit. The fundamental assumption of technical analysis holds that past performance can inform future movements. Moving averages play a central role in the determination of past price trends.
Several different kinds of moving average calculations exist, but all of them are used to plot a line against either a price chart or another indicator. The direction and slope of moving average lines inform investors about the relationship between historical data values and present data values. The trading concepts of divergence, confirmation, overbought and oversold, support and resistance, and many others have their roots in moving average analysis.
The flexibility of moving averages allows them to be used to analyze other moving averages. A common strategy among chartists and analysts involves plotting two moving average lines of different time intervals and interpreting their relationship to spot trends, forecast price movements and place trades. Moving average crossovers have subsequently become the focus of an entire subset of technical indicators.
Moving averages are not without shortcomings, but their importance to technical stock market trading would be difficult to overstate.
(For related reading, see "Moving Averages.")