Moving averages are technical indicators used by traders and investors to define the current price direction rather than predict the price direction. The most common types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). Both SMA and EMA are used to measure the direction of price over a given period or spot any trend reversals.
Simple Moving Average determines an average of price data whereas Exponential Moving Average gives more weight to recent price data. The difference between SMA and EMA becomes noticeable when comparing long-term averages.
Simple Moving Average Calculation
The SMA gives an average price of a security over a certain period. SMA as exactly as the name implies is the average of a set number of inputs, as chosen by the trader. In the instance of an SMA, these inputs will be closing prices. If you have ten price inputs (i.e., closing prices from the last ten days), you will add these together and divide the total by ten.
Exponential Moving Average Calculation
To work out an EMA, you start with the SMA data. A multiplier is added, increasing the weighting of the newer price data. The formula for working out the multiplier, which is then used in the calculations for EMA is as follows:
Multiplier formula: (2 / [time periods + 1]) = (2 / [10 + 1])
Simple vs. Exponential Moving Averages: The Difference Explained
Even though SMA and EMA show distinctive differences, that does not mean one is superior to the other. It depends on factors like a trader’s style of analysis, objectives, and time horizon. Each stock or index has its own frequency (use backtesting experiments to figure it out). Sometimes, for a particular period, SMA reacts better and sometimes EMA does. The longer the time, the slower it is for the moving average to react to movement in price.
SMA is most useful for long-term trading while EMA is more useful where there is short-term price movement. The same features that make the EMA a better choice for short-term trading make it less effective when it comes to long-term trading.
Considering that the EMA will move with price sooner than the SMA, it often makes a sudden switch in price direction. A price spike therefore may send the wrong signal of a forming trend.
The SMA, with its slower lag, tends to smooth price action over time. This makes it a good trend indicator, as it remains short when the price is below the SMA and long when the price is above it. SMA’s will give you an overall view of trends making it easier to identify fake-outs. Traders need to try out different strategies and backtest the chart to see which makes more returns with all types of moving averages of 10, 5, 20, 50, 200 SMA, and 200 EMA.
EMA vs SMA Verdict
Over the years in my trading career, I have learned that EMA is typically smoother and more accurate hence the potential to provide a higher number of relevant results. EMA reduces the effect of the lag that comes from using previous price data by using current data. This helps you identify a trend earlier. It’s a useful indicator for trading short-term momentum, with its major benefit being the speed with which it reacts to the markets.In conclusion, it is right to say that each trend has its own merits. While the SMA is slow to respond to price action, using this indicator may help you avoid many fake-outs. However, I personally don't rely on SMA's when looking at charts and making trading decisions.
On the other hand, using the EMA indicator will aid you in catching a trend as it starts, but if you are a slow trader, you risk getting caught up in fake-outs of price spikes. It will take some experience and a cluster of indicators to help you avoid the fake-outs (i.e. use Bollinger Bands in conjunction with EMAs).
I leave it up to the reader, to experiment with both the EMA and SMA, to get a feel of what works for them and what does not.
For those wanting to take things to the next level, take a look at our article on EMA Clouds, which is a highly regarded new technical indicator.
Enjoyed this article? Check out Why Mastering Bollinger Bands Is A Must. Be sure to also check out the Elder Impulse Momentum trading system which heavily relies on EMAs. If you are looking for a start trading system, the Elder Impulse system is the perfect place to start.