It is, in a sense, one of the most elemental human desires – to know what the future will bring. Or, at least, to have some idea.
Financial markets are not immune to this desire. Far from it. Since the establishment of organised exchanges for the buying and selling of financial assets, traders and investors have sought out ways to get an edge over their competitors by having a clearer idea than they do which way individual prices, and the market as a whole, are moving.
Some of this soothsaying was just plain silly. One example held that when the US dollar was at a certain rate against the Italian lira (now subsumed into the euro) this would automatically trigger assorted market movements.
Taking a well-founded view
For such an assertion, there was little evidence, and the whole notion sounds more like astrology than serious financial analysis.
Other times, the forecasters’ brilliance was easily explained when it emerged that they had been privy to inside information.
This is especially useful for those trading contracts-for-difference (CFDs). Whereas future price movements are an important feature of most trading and investment, CFD trading is centred entirely on taking a view on where prices are going, a view that needs to be based the proper use of reliable techniques.
Of these, moving average is one of the best-known. Simple enough in concept, it conceals some hidden complications, albeit ones that can be mastered.
As the name suggests, it represents the average price of any financial asset –shares, commodities, currencies, indices or bonds – over any time period, the period in question being of any duration, from a few minutes to many months or beyond, depending on the timeframe for the trading strategy. So, in very simple terms, a security that traded at $1 on Monday, $2 on Tuesday, $1 on Wednesday, $1.5 on Thursday, and closed the week at $2 on Friday had a moving average across those five days of $1.5.
Adding in some weight
What does it tell you about where the asset will open when trading re-opens on Monday? The short answer is, a lot more than if you had been given Friday’s $2 close, on its own, with no context.
That is, of course, a very simplified example. But it does explain the principle. For a trader, and there are many, who takes the view that “the trend is your friend”, that sort of moving average may well prompt a buying opportunity.
A declining moving average, in our example from $2 on Monday to $1 on Tuesday, to $0.5 on Wednesday, to $2 on Thursday and $1.5 on Friday, would have put such traders in a selling frame of mind.