Of the hundreds of technical analysis1 studies and indicators available for traders, perhaps none is more widely used than the moving average. Guess what? There are several types of moving averages based on different calculations. Understanding which moving average to use and when to use it is important to understand before adding moving averages to your charting basics toolbox.
Moving averages smooth price data to form a trend-following technical indicator. They do not predict price direction; instead, they define the current direction with a lag.
Simple moving average
As the name might imply, the simple moving average2 (SMA) is the most basic form of this technical indicator. For stocks, it's calculated by adding all closing prices for a specific number of time periods, then dividing that total by the number of periods.
For example, if a trader wanted to find the current 10-day SMA of a stock, they'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.
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 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%.
Here's how to calculate the multiplier for the 10-day EMA:
{2 / (time periods + 1) } = {2 / (10 + 1) } = 0.1818 (18.18%)
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 moves beyond two times the length of the average, the weighting is so infinitesimal that it's irrelevant.
When to use each 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 EMA will track price more closely than an SMA. 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's below. A simple moving average can also be effective as a support and resistance indicator.
The chart below compares both types of averages applied to one individual stock, showing how the EMA (yellow line) tracked price slightly better than the SMA (blue line), although both provide support for the general trend. On occasion, however, the EMA generated a false breakout signal. Using the SMA, the signal comes only after the trend is fully re-established.
Source: thinkorswim® platform
For illustrative purposes only. Past performance does not guarantee future results.
Some traders like to use moving averages in conjunction with other technical indicators and overlays to get a more comprehensive picture. For example, traders can consider experimenting with a moving average and a momentum indicator like the stochastic oscillator, moving average convergence divergence (MACD)3, or the Relative Strength Index (RSI).
1Technical analysis examines historical trading data, such as price and volume data, to identify previous chart patterns with the hope of anticipating stock price movements. Some technical analysis tools include moving averages, oscillators, and trendlines.
2A simple moving average (SMA) is a technical indicator that's calculated by adding the closing price of a stock or other security over a specific period of time and dividing the total by the appropriate number of trading days. For example, a 20-day SMA is the average closing price over the previous 20 days.
3A moving average convergence divergence (MACD) is an oscillator in which entry and exit signals trigger when the indicator moves above or below the zero line. When the indicator is below the zero line and moves above it, this is a bullish signal. A move below the line is a bearish signal.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.