zenduck.me: Comparing Simple vs Exponential Moving Averages

Simple vs. Exponential Moving Averages: An Overview

Traders use moving averages (MA) to pinpoint trade areas, identify trends, and analyze markets. Moving averages help traders isolate the trend in a security or market, or the lack of one, and can also signal when a trend may be reversing. Two of the most common types are simple and exponential. We will look at the differences between these two moving averages, helping traders determine which one to use.

Moving averages reveal the average price of a tradable instrument over a given period of time. However, there are different ways to calculate averages, and this is why there are different types of moving averages. They are called “moving” because, as the price moves, new data is added to the calculation, therefore changing the average.

Simple Moving Average

To calculate a 10-day simple moving average (SMA), add the closing prices of the last 10 days and divide by 10. To calculate a 20-day moving average, add the closing prices over a 20-day period and divide by 20.

Given the following series of prices:

• $10, $11, $11, $12, $14, $15, $17, $19, $20, $21

The SMA calculation would look like this:

• $10+$11+$11+$12+$14+$15+$17+$19+$20+$21 = $150

10-day period SMA = $150/10 = $15

Old data is dropped in favor of new data. A 10-day moving average is thus recalculated by adding the new day and dropping the 10th day, and this process continues indefinitely.

The exponential moving average (EMA) focuses more on recent prices than on a long series of data points, as the simple moving average required.

To Calculate an EMA

Current EMA = ((Price(current) – previous EMA) X multiplier) + previous EMA

The most important factor is the smoothing constant that = 2/(1+N) where N = the number of days.

A 10-day EMA = 2/(1+10) = 0.1818

For example, a 10-day EMA weights the most recent price at 18.18%, with each data point after that being worth less and less.

The EMA works by weighting the difference between the current period’s price and the previous EMA and adding the result to the previous EMA. The shorter the period, the more weight applied to the most recent price.

Key Differences

SMA and EMA are calculated differently. The calculation makes the EMA quicker to react to price changes and the SMA reacts slower. That is the main difference between the two. One is not necessarily better than another.

Sometimes the EMA will react quickly, causing a trader to get out of a trade on a market hiccup, while the slower-moving SMA keeps the person in the trade, resulting in a bigger profit after the hiccup is finished. At other times, the opposite could happen. The faster-moving EMA signals trouble quicker than the SMA, and so the EMA trader gets out of harm’s way quicker, saving that person time and money.

Note that with an EMA, each data point included in the average decreases in weight over time, until it is ultimately removed as new data points are added that carry higher weights. So in the case of a 10-day EMA, the weight of a new data point on day one would drop to just 6.67% of its initial weight after five closing prices.

Each trader must decide which MA is better for his or her particular strategy. Many shorter-term traders use EMAs because they want to be alerted as soon as the price is moving the other way. Longer-term traders tend to rely on SMAs since these investors aren’t rushing to act and prefer to be less actively engaged in their trades.

As a general guideline, when the price is above a simple or exponential MA, then the trend is up, and when the price is below the MA, the trend is down. For this guideline to be of use, the moving average should have provided insights into trends and trend changes in the past. Pick a calculation period—such as 10, 20, 50, 100, or 200—that highlights the trend, but when the price moves through, it tends to show a reversal. This applies whether using a simple or exponential MA.

Test out various MAs to see which works best by altering the inputs on the indicator in your charting platform. Different MAs make work better on different types of financial instruments, including stocks.

Special Considerations

As lagging indicators, moving averages serve well as support and resistance lines. During an uptrend, the price will often pull back to the MA area and then bounce off it.

If prices break below the MA in an upward trend, the upward trend may be waning, or at least the market may be consolidating. If prices break above a moving average in a downtrend, the trend may be starting to move up or consolidating. In this case, a trader may watch for the price to move through the MA to signal an opportunity or danger.

Other traders aren’t as concerned about prices moving through the MA but will instead put two MAs of different lengths on their chart and then watch for the MAs to cross.

Sometimes, the MA crossovers provided very good signals that would have resulted in large profits, and other times, the crossovers resulted in poor signals. This highlights one of the weaknesses of moving averages. They work well when the price is making large trending moves but tend to do poorly when the price is moving sideways.

For longer-term periods, watch the 50- and 100-day, or 100- and 200-day moving averages for longer-term direction. For example, using the 100- and 200-day moving averages, if the 100-day moving average crosses below the 200-day average, it’s called the death cross. A significant down move is already underway. A 100-day moving average that crosses above a 200-day moving average is called the golden cross and indicates that the price has been rising and may continue to do so. Shorter-term traders may watch an 8- and 20-period MA, for example. The combinations are endless.