What is a Moving Average (MA)?
A moving average is a statistical analysis tool used to smooth out fluctuations in data over time by calculating the average of a set of data points. The term "moving average" refers to the fact that the data points used in the calculation are constantly moving, or updating, as new data becomes available. The purpose of using a moving average is to identify trends and patterns in data that might not be immediately apparent from looking at the raw data alone.
There are two types of moving averages: simple moving average and weighted moving average. A simple moving average is calculated by summing up a set of data points and dividing by the number of data points in the set. A weighted moving average, on the other hand, assigns more weight to recent data points and less weight to older data points.
Moving averages can be used in a variety of applications, including stock market analysis, economic forecasting, and quality control. In stock market analysis, for example, moving averages can be used to identify trends in stock prices and to determine whether a stock is overbought or oversold. In economic forecasting, moving averages can be used to smooth out fluctuations in economic data such as GDP or inflation rates and to identify trends in the economy.
The length of the moving average, also known as the window size, is an important consideration when using moving averages. A longer window size will result in a smoother average, but it will also result in a slower response to changes in the data. A shorter window size will result in a more responsive average, but it will also result in a greater degree of fluctuation in the average.
Simplified Example
Think of a moving average like a game of catch with a friend. Imagine that you and your friend are playing catch with a ball, and every time you catch the ball, you count how many catches you've made. The average number of catches is just the total number of catches divided by the number of times you've played.
Now, instead of counting the catches one by one, let's say you want to keep track of the average number of catches over the last three times you played. So, you add up the number of catches from the last three times and divide by three. That gives you the moving average of catches for the last three times you played.
Every time you play catch again, you add the number of catches from that time to your running total and then divide by three again to get the updated moving average. This way, you always have an average of the last three times you played, even as the actual number of catches changes with each game.
The moving average helps smooth out any fluctuations in the number of catches so you can see the overall trend, just like how a moving average can help smooth out fluctuations in data to help identify trends.
History of the Term "Moving Average"
Imagine a world before spreadsheets and fancy data analysis tools. People dealt with messy, fluctuating numbers – crop yields, market prices, you name it. How did they make sense of it all?
Enter R.H. Hooker, a 1901 stats whiz. He devised these "instantaneous averages," like snapshots of ever-changing data. Think of it like taking a picture of a flowing river to see its general direction.
A few years later, G.U. Yule, another stats guru, stumbled upon Hooker's work. He liked the idea, but the name? Not so much. He mumbled something about "moving-averages," but it didn't stick.
Fast forward to 1912. W.I. King, a textbook author, enters the scene. He sees the potential in these "moving-averages." He polishes the term, throws it in his book, and bam! It's like he throws a lit match onto dry tinder.
The stats world explodes with "moving averages." Everyone's using them, from farmers tracking crop yields to businessmen analyzing market trends. The term becomes the go-to tool for taming wild data.
Examples
Simple Moving Average (SMA): This is the simplest form of moving average and is calculated by adding up a set of data points and dividing by the number of data points in the set. For example, a 10-day simple moving average would be calculated by adding up the prices of a stock for the last 10 days and dividing by 10. This type of moving average is commonly used in stock market analysis to identify trends in stock prices.
Exponential Moving Average (EMA): This type of moving average gives more weight to recent data points, making it more responsive to changes in the data. The EMA is calculated by adding a percentage of the current data point to the previous EMA. For example, a 10-day EMA would give more weight to the last 10 days of data, while a 50-day EMA would give more weight to the last 50 days of data.
Weighted Moving Average (WMA): This type of moving average assigns different weights to different data points based on their position in the set. For example, a 5-day weighted moving average would assign more weight to the most recent data point and less weight to the older data points. This type of moving average is commonly used in quality control to identify trends in data such as production rates or product quality.