Day traders and investors alike often miss out when they choose one over the other.
In this post, we lay out the differences and explain the advantages and disadvantages of each. We are also going to look at how each moving average is calculated.
What is a moving average?
As the name suggests, a moving average indicator is a line that represents the mean average of the price of a stock over a given number of intervals.
For example, a 20-day moving average calculates the average price over the past 20 days, while a 50-day moving average is used to calculate the average price over the past 50 days.
Moving averages are one of the most common tools that day traders rely on when attempting to understand the movement of stock prices because they add a layer to every chart analysis you’re doing, pointing out exactly where the price action is taking place.
Based on pure popularity, the simple moving average and the exponential moving average are the most widely used technical indicators.
Let’s take a closer look at each of these averages.
What is a simple moving average?
A simple moving average, also commonly referred to as arithmetic moving average, is a calculation of the average price of stock or security according to the number of periods in the range.
It can also be defined as the simple calculation of the last few candles in a chart. This moving average usually weights each candle with its corresponding closing price equally, without giving one candle’s closing price more consideration than the other.
Traders use the SMA to overlay charts with long-term price trends to check how a long-term average compares with current prices.
Generally, short-term SMAs (e.g. 50-day) respond faster to dramatic price swings, while long-term SMAs (e.g. 200-day) are slow.
A simple moving average is calculated by adding up all price observations in a chosen range and then diving that sum by the number of time periods within the range.
The average then begins “moving” because one continues to average the price data for that range by incrementally advancing one period at a time.
The SMA is one of the easiest trend indicators to use and is also quite simple to calculate using a spreadsheet or by hand.
The formula for computing the simple moving average is:
SMA = (X1+X2+X3+…Xy)/y
Xy = The price of a stock at observation #y
y = The number of total periods or observations
Suppose the closing price of a stock in the last 20 days are 1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16,17,18,19,20…the SMA is 1+2+3+4+5+6+7+8+9+10+11+12+13+14+15+16+17+18+19+20/20 = 10.5…here 20 is the number of days.
As new closing prices keep trickling in, the average is recalculated thus forming a “moving average.”
What is the exponential moving average?
An exponential moving average is a technical indicator whose calculation gives more weight to the most recent prices.
Consequently, EMA responds at a faster pace to the latest price changes, compared to an SMA, which has a bigger lag. When using an EMA to trade, the main goal is to smooth out prices and get rid of short-term fluctuations.
This responsiveness of the EMA to new data relative to the simple moving average is one of the main reasons why it is the choice for many stock traders. Traders widely consider it much more efficient than the SMA.
The calculation of the exponential moving average might seem a bit complicated, but in practice, it’s not challenging.
In fact, calculating EMA is much easier than SMA, and on top of that, most charting platforms will do it for you. The formula for calculating EMA is as follows:
EMA = (K x (C – P)) + P
K = Exponential smoothing constant
C = Current Price
P = Previous periods EMA (A simple moving average is used for the first periods calculations)
The smoothing constant K, puts appropriate weight on the newest price and uses the number of periods stipulated in the moving average.
Which moving average is best for day traders?
The stock market can be very speculative and this sometimes results in exaggerated volatility levels. To compensate, day traders, position traders, and long-term traders alike use a variety of technical analysis indicators that are designed to smooth out the effects of volatility.
Both simple moving average and exponential moving average are some of the most common indicators that are used by traders to indicate overall trend direction.
Each moving average has its advantages and disadvantages and can be successfully used in different scenarios. The EMA puts a lot of focus on the most recent price data and this is often why active traders prefer it.
When should you use a simple moving average?
The simple moving average is a powerful technical indicator that is widely popular in financial markets. Its versatility is what makes it continually relevant and so strong.
Day traders apply simple moving averages by looking for trends and reversals, determining potential areas where a stock will find support or resistance, and measuring the strength of a stock’s momentum.
A simple moving average works well when using longer time frames because they are slower and smoother, and thus give traders an idea of the general trend.
The general trend of using an SMA is that it can delay you too long. This means you could end up missing out on a good price to enter a trade or the entire trade.
The simple moving average is not the most sophisticated technical analysis tool in the world, but it is still worth trying out as it can be of value to your trading strategy.
When should you use an exponential moving average?
The exponential moving average is widely considered more ideal for day trading and other short-term trading strategies.
A short period exponential moving average is the best way to go if you want a moving average that will respond to price rather fast.
Exponential moving averages may also help you to identify trends very early, and this can result in high profits. The quicker you spot a trend, the longer you can ride it and rake in big gains.
The drawback of relying on this moving average is that it responds very fast to prices, a trader might confuse a fake-out for a trend during a consolidation period. This would be the case of a technical analysis tool being too quick for your good.
Which moving average should you consider when day trading? Well, it ultimately boils down to your personal preference and there is certainly no wrong in plotting both SMA and EMA on trading charts and checking how they compare.
Look for a chart and begin playing with both of these moving averages. Give each a try while experimenting with different time periods. In the end, you’re going to know the one that suits your trading style.