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What is a moving average? How is it used to determine the future price of a stock?

A moving average is used to predict the future direction of a stock price. Such an indicator is used on the assumption that all known influences are fully reflected in market prices. By studying market action i.e. price and volume, the “technical” analysts rely on the market to indicate the direction and extent of its next price move.

The key premise on which technical analysis is based is that prices move in trends and trends tend to persist for long periods of time – this is why technical analysis is known as momentum investing. The primary objective of technical analysis is to identify trends, preferably in the early stages, and carry positions in that direction until the trend reverses itself. The methods used to identify trends and trend turning points can be divided into three board categories: chart analysis, statistical analysis and analysis of sentiment indicators. They are usually used together. Statistical analysis includes two tools -- moving averages and momentum indicators. Moving averages are lagging indicators that are designed to indicate buying or selling opportunities once a trend is firmly established. Moving averages smooth out price movements to identify the underlying trend of the market. Before using a moving average, the type of moving average and the number of days to be averaged must be chosen. A ten-day moving average is simply the total of the last ten trading closes divided by 10. On the eleventh day, the new closing price is added and the closing price from eleven days before is subtracted. A simple moving average give equal weight to each day during the period. Weighted and exponential moving averages give more weight to recent prices. The most popular long term moving average for market averages is the 40 week (or 200 day) moving average. This moving average has a good track record in identifying primary trends. Although moving averages are useful indicators, they identify changes after they occur. Momentum indicators, which are used to detect a warning signal before a trend takes place, measure the rate of change of a security price or market average. The simplest method of calculating momentum is to take the current price and divide it by the price that was posted several days, weeks or months ago. To measure the 30-day rate of change the current price is divided by the price 30 days ago and the result multiplied by 100. If the price was $50 and the and the price 30 days ago was $45, the 30 day rate of change or momentum index is 111 (50/45 * 100). If, on the following day, the price is $52 and the price 30 days before was $46, the momentum index is 113. These indexes show that the price momentum is upwards. The momentum indicator turns up or down before a turn in the stock market average. As a result, the indicator can signal a change in trend.