Simple Moving Average and Exponential Moving Averages Explained
Simple moving averages ( SMA ) and exponential moving averages ( EMA ) are both technical indicators that are used to help identify the trend of a stock over different periods of time. As such, the trader might want to see the trend of a stock over a 10, 20, or even 200 day period as it compares the the actual path of the stock.
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Simple and Exponential Moving Averges
Learn how simple and exponential moving averages can be used to read the the trend of a stock compared to the average movement of the stock over different time periods.
Moving averages are likely the most commonly used technical analysis tool used in trading stocks and options. It is very important to understand that it is a lagging indicator and that moving averages do not predict the future movement of the stock.
Based on its data, however, moving averages can visually show how the stock performed on average for a historical period of time before. The most commonly used time-frames are 10, 20, 50, or 150 days; and can be seen as a sloping line that follows the movement of a stock.
The trader can see trends in how the underlying stock is performing relative to the time period. If a stock falls below one of the moving averages, the trader will be able to visually see that his/her stock is beginning to underperform. The underperformance might not be so bad in a shorter timeframe like 10 days, but might be perceived as terrible if the stock falls below the 150 day moving average.
If a stock begins to trade below the trend line of a moving average, that indicates that the stock is under-performing compared to how it was performing over a given period of time. So if a stock moves below a 10 day moving average, the stock is under-performing how it did over the last 10 days on average. This is obviosly a short term indicator. If the stock falls below the 50 or even the 150 day moving averages, this trend would be more worrisome.
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What is a Simple Moving Average?
As the name might imply, the simple moving average (SMA) is the most basic form of this technical indicator. For stocks, it’s calculated by adding together all closing prices for a specific number of time periods, then dividing that total by the number of periods.
For example, if you wanted to find the current 10-day SMA of a stock, you’d add up each of the closing prices for the last 10 days and then divide by 10. With each new day moving forward, the first day of that 10-day series would be dropped from the calculation and the new day would be added.
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What is an Exponential Moving Average?
The exponential moving average (EMA) is the more sophisticated cousin to the SMA. The calculation starts out the same as the SMA but is modified so that the most recent data points in the series have more weight than the older ones. As fresher data points become stale, their weighting in the calculation decreases exponentially—hence the name.
For example, in a 10-day EMA, the most recent data point would count as 18.2% of the total calculation, but the oldest would count as only 3%.
An interesting quirk of the EMA is that only about 87% of the data used to calculate the indicator is taken from the actual number of charted price bars in the length of the average. Because of the nature of the exponential decay, data for an EMA is taken from an infinite amount of historical periods. Although for all practical purposes, once it gets beyond two times the length of the average, the weighting is so infinitesimal that it’s irrelevant.
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How do you calculate the exponential moving average?
10-day EMA:
{2 / (time periods + 1) } = {2 / (10 + 1) } = 0.1818 (18.18%)
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When would you use a simple moving average over an exponential moving average?
With moving averages in general, the longer the time period, the slower it is to react to price movement. But everything else being equal, an exponential moving average will track price more closely than a simple moving average. Because of this, the EMA is typically considered more appropriate in short-term trading.
The same characteristics that make the EMA better suited for short-term trading limit its effectiveness when it comes to the long term. Although the EMA will move with price sooner than the SMA, it often gets whipsawed, making it less than ideal for triggering entries and exits on daily charts.
The SMA, with its built-in lag, tends to smooth price action over time, making it a good trend indicator—staying long when price is above the average and flat (or short) when it is below. A simple moving average can also be effective as a support and resistance indicator. Figure 1 compares both types applied to one individual stock.
Some traders like to use moving averages in conjunction with other technical indicators and overlays to get a more complete picture. For example, consider experimenting with a moving average along with a momentum indicator such as a stochastic oscillator, moving average convergence divergence (MACD), or the Relative Strength Index (RSI).
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