Comparing Simple vs. Exponential Moving Averages

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Comparing Simple vs. Exponential Moving Averages

Simple vs. Exponential Moving Averages: An Overview

Moving averages (MA) are used by traders to find trading regions, detect trends, and evaluate markets. Moving averages assist traders in isolating the trend in a security or market, or the lack thereof, and may also suggest when a trend is about to reverse. Simple and exponential are two of the most frequent varieties. We will examine the distinctions between these two moving averages in order to assist traders in deciding which to utilize.

Moving averages reflect the average price of a tradable item over a certain time period. However, there are several methods for calculating averages, which is why there are various kinds of moving averages. They are named “moving” because when the price fluctuates, fresh data is added to the computation, causing the average to change.

Key Takeaways

  • Moving averages (MAs) serve as the foundation for chart and time series analysis.
  • Simple moving averages and more advanced exponential moving averages aid in trend visualization by smoothing out price fluctuations.
  • One sort of MA isn’t inherently better than another, but depending on how a trader employs moving averages, one may be preferable.

Simple Moving Average

To construct a 10-day simple moving average (SMA), sum the past 10 days’ closing prices and divide by 10. To construct a 20-day moving average, sum the closing prices for the previous 20 days 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 being phased out in favor of fresh data. A ten-day moving average is therefore computed by adding the new day and subtracting the tenth, and this procedure is repeated forever.

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Exponential Moving Average

The exponential moving average (EMA) prioritizes current prices over a lengthy sequence of data points, as the basic moving average does.

To Calculate an EMA

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

The smoothing constant, which equals 2/(1+N) where N is the number of days, is the most essential element.

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

A 10-day EMA, for example, weights the most recent price at 18.18%, with each data point following that contributing less and less.

The EMA calculates the difference in price between the current period and the previous EMA and adds the result to the previous EMA. The most recent price is given greater weight the shorter the time.

Key Differences

The SMA and EMA are computed in various ways. The formula causes the EMA to respond faster to price movements and the SMA to react slower. That is the primary distinction between the two. One is not always superior to another.

Sometimes the EMA reacts rapidly, leading a trader to exit a trade during a market hiccup, but the slower-moving SMA maintains the trader in the deal, resulting in a larger profit after the hiccup is through. At occasion, the reverse might occur. The faster-moving EMA flags problems faster than the slower-moving SMA, thus the EMAtrader gets out of harm’s way sooner, saving time and money.

With an EMA, each data point included in the average loses weight over time until it is eventually deleted when new data points with greater weights are added. With a 10-day EMA, the weight of a fresh data point on day one would be 6.67% of its original weight after five closing prices.

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Each trader must choose which MA is best for his or her own approach. Many shorter-term traders utilize EMAs because they want to be notified when the price moves in the other direction. Longer-term traders depend on SMAs since they are not in a hurry to act and want to be less actively involved in their transactions.

It all boils down to personal choice in the end. On a chart, plot an EMA and a SMA of the same duration to discover which one helps you make better trading choices.

When the price is above a simple or exponential moving average (MA), the trend is up; when the price is below the MA, the trend is down. In order for this recommendation to be useful, the moving average should have previously offered insights into trends and trend shifts. Choose a computation period—say, 10, 20, 50, 100, or 200—that accentuates the trend but tends to indicate a reversal when the price goes through. This is true whether the MA is simple or exponential.

Change the inputs on the indicator in your charting tool to try out different MAs and discover which one performs best. Different MAs perform better on various financial products, including stocks.

Special Considerations

Moving averages work effectively as support and resistance lines as lagging indicators. During an uptrend, price will often draw back to the MA and then rebound off of it.

If prices fall below the MA during an upward trend, the trend may be fading or the market may be consolidating. In a downtrend, if prices break above a moving average, the trend may be reversing or consolidating. In this situation, a trader may look for price movement through the MA to signify an opportunity or risk.

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Other traders are less concerned with prices going through the MA and will instead place two MAs of varying lengths on their chart and wait for the MAs to cross.

MA crossovers generated extremely excellent indications that would have led in significant gains at times, and bad signals at other times. This demonstrates one of moving averages’ flaws. They perform well when the price is trending but perform badly when the price is drifting sideways.

Watch the 50- and 100-day moving averages, or the 100- and 200-day moving averages, for longer-term direction. For example, using the 100- and 200-day moving averages, the death cross occurs when the 100-day moving average crosses below the 200-day moving average. A strong downward trend has already begun. The golden cross occurs when a 100-day moving average crosses over a 200-day moving average and signals that the price has been increasing and may continue to rise. Short-term traders may be interested in an 8- and 20-period moving average, for example. The possibilities are infinite.

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