An indicator is a formula when placed against price will hopefully reveal the directional bias of a stock.  Last week we talked about how a simple moving average is determined.  The purpose of any moving average is to smooth price action and give the trader a sense of where the stock is trending. 

Moving averages are lagging indicators and are many times used to confirm direction.  Major moving averages like the 20, 50 and 200 day simple can be used as areas of support and resistance.  Sometimes moving averages are used for buy and sell signal when a shorter term moving average crosses over a longer term moving average.

A moving average can be adjusted to react more quickly to price movement and therefore not lag quite as much as a simple moving average.  The purpose of doing this is so that the moving average can act more as a buy/sell signal.  An example of this is the Weighted Moving Average.  This average weights recent price action more heavily.  Following is the formula for the Weighted Moving Average.

               If using a 5 day weighted moving average, the most recent day’s price receives the greatest importance.  The weighting would be in multiples as follows:  5+4+3+2+1 =15.  Today’s price would receive a weight of 5, yesterday would receive a weight of 4 and so on.  In this example, the total numerical weightings add up to 15.  We then divide the total prices from the five trading days by the sum of the weights (15) to arrive at the most recent plot point for the weighted moving average.  Using last week’s Simple Moving Average numbers, let’s recalculate for the weighted moving average.

Day 1 – $44.60 – 5 days ago, multiply by 1

Day 2 – $88.70 – 4 days ago, multiply by 2

Day 3 – $130.98 – 3 days ago, multiply by 3

Day 4 – $173.76 – 2 days ago, multiply by 4

Day 5 – $220.70 – today’s price, multiply by 5

Total = $658.74 / 15 = $43.92

              This data point would be plotted.  As each day closes, the new data point is plotted and the prior day receives less importance the older it becomes.  Exponential Moving Averages are a bit more complex as it uses a constant or exponent that acts as a multiplier against the difference between one day’s price and the next.  No need to panic, most charting packages have it all figured out for you.  The important thing to know is that weighted or exponential moving averages take some of the lag out of the moving average and it becomes less of a trend following indicator and more of a leading indicator.  Best, Robin

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