Investments, tenth edition

  Momentum and Moving Averages   

While we all would like to buy shares in 

firms whose prices are trending upward, this begs the question of how to identify the 

underlying direction of prices, if in fact such trends actually exist. A popular tool used for 

this purpose is the moving average. 

 The moving average of a stock price is the average price over a given interval, where 

that interval is updated as time passes. For example, a 50-day moving average traces the 

average price over the previous 50 days. The average is recomputed each day by dropping 

the oldest observation and adding the newest.  Figure 12.3  is a moving average chart for 

Intel. Notice that the moving average (the colored curve) is a “smoothed” version of the 

original data series (the jagged dark curve).  

 After a period in which prices have been falling, the moving average will be above the 

current price (because the moving average continues to average in the older and higher 

prices until they leave the sample period). In contrast, when prices have been rising, the 

moving average will be below the current price. 

 Prices breaking through the moving average from below, as at point A in  Figure 12.3 , is 

taken as a bullish signal, because it signifies a shift from a falling trend (with prices below 

the moving average) to a rising trend (with prices above the moving average). Conversely, 

when prices drop below the moving average, as at point B, analysts might conclude that 

market momentum has become negative.