Moving Averages

Sometimes simple stuff works

People have been looking at lines for a long time. For people who like stocks, they are particularly into lines of the Dow Jones Industrial Average or the S&P 500 (if you are a snob who likes well-diversified baskets of stocks).

The Dow Jones Industrial Average has been around for such a long time, that your parents, grandparents, and maybe even great grandparents have seen it. Pretty cool to think that we are seeing a line that is a continuation of what they saw back in the day.

We don’t know what is to come but barring a giant meteor, the lines of today will continue on and the next generation will see them too. They’ll probably say “Wow, can you believe the S&P 500 was only at 3,000 back then? So, weird now that it’s 30,000.” (And, yes, they will be talking about the S&P 500 and not the Dow because they will be raised to be well-diversified stock snobs.)

Anyways, what’s cool about lines is that you can do some math stuff and change them around. One day, somebody was looking at a line for stocks and thought, “Gee, this is super volatile. Maybe I can smooth it out somehow?” Then they started averaging consecutive days of index results and created a moving average. Somewhere along the line (pun not intended but I am definitely keeping that in writing), people decided that 200 consecutive days was a nice standard (but certainly not the only one) to use for smoothing:

So smooth! Unlike that choppy, volatile atrocity that is the regular S&P 500, the lighter line of the moving average is nice and calm. I am imagining some utopia where every trader is super Zen and things are calm like the moving average is. Instead, reality is the darker line where everyone is buying and selling like a bunch of savages.

The value of a moving average is already apparent then. We can compare the insanity of the regular stock market against this alternative universe where everyone goes about their business in a level-headed manner. This creates a really nice benchmark. If stocks are trading above the moving average, mania has taken hold. If stocks are trading below, barbarians are at the gate. At least, that’s one interpretation of it that’s completely unscientific but kind of fun.

All that being said, I’ve surprised myself with how much I’ve been able to write about something that is supposed to be super simple. In short, a moving average is a common technique for time series transformation and very popular due to its simplicity. There are some neat applications for it as well, which I will be sure to cover soon. Until then, enjoy the lines!