Traders use moving averages (MA) to pinpoint trade areas and to analyze markets. MAs help traders isolate the trend, or lack of one, and can also signal when a trend may be reversing. Two of the most common MA types are the simple and exponential. We will look at the differences between these two MAs, helping traders determine which one to use.
Moving averages reveal the average price of a tradable instrument over a given time period. 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 into the calculation, thus changing the average.
Simple Moving Average (SMA)
To calculate a 10-day simple moving average, 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, $12, $16, $17, $19, $20
The SMA calculation would look like this:
$10+$11+$12+$16+$17+$19+$20 = $105
7-period SMA = $105/7 = $15
Old data is dropped in favor of new data. A 10-day average is recalculated by adding the new day and dropping the 10th day, and this process continues indefinitely. (For additional reading, see: Chart Basics Walkthrough.)
The following chart shows a 100-day SMA applied to a chart of Macys, Inc. (M). It helps highlight the downtrend on the left and the rally on the right of the chart. At any given time, this SMA line is showing the average price of the most recent 100 trading sessions/candles.
Exponential Moving Average (EMA)
The exponential moving average (EMA) focuses more on most recent prices rather 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-period 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.
Differences Between MAs
The SMA and EMA are calculated differently. And it is the calculation that makes the EMA quicker to react to price changes and the SMA react slower. That is the main difference between the two. One is not necessarily better than another, though.
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.
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 price is moving the other way. Longer-term traders tend to rely on SMAs, since these investors aren't in rush to act and prefer to be less actively engaged in their trades.
Ultimately, it comes down to personal preference. Plot an EMA and SMA of the same length on a chart and see which one helps you make better trading decisions.
The following chart shows a 100-day SMA (blue) and EMA (pink) on a chart of Alphabet Inc. (GOOG). The EMA reacts quicker to price changes and tends to cling closer to the price action. The SMA is slower to react and has a tendency to stay further from the price, giving it more room.
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 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. (See also: How to Use Moving Averages to Buy Stocks.)
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, as can be seen a number of times on the chart above.
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 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 length on their chart and then watch for the MAs to cross.
The chart below uses a 50- and 100-day SMA in the SPDR S&P 500 ETF (SPY). 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 price is making large trending moves but tend to do poorly when the price is moving sideways like it was on the left-hand side of the chart.
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 under way. 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.
The Bottom Line
Moving averages are the basis of chart and time series analysis. Simple moving averages and the more complex exponential moving averages help visualize the trend by smoothing out price movements. One type of MA isn't necessarily better than another, but depending on how a trader trades, one may be better for that particular individual. (For more, check out our Moving Averages tutorial.)