Comparing Simple Moving Averages and Exponential Moving Averages in Trading - dummies

Comparing Simple Moving Averages and Exponential Moving Averages in Trading

By Joe Duarte

Both simple moving averages (SMAs) and exponential moving averages (EMAs) are used regularly by long‐term investors, position traders, and short‐term traders alike. Each moving average has its strengths and weaknesses. Which you choose can be a matter of personal preference, but one may be better suited than the other depending on the time frame you’re trading. Most position traders use a combination of both SMAs and EMAs.

Consistency

The SMA has the benefit of being consistently calculated from one charting platform to the next. If you ask for a 20‐period SMA, you can be certain that the result will be identical to every other 20‐period SMA for the same stock during the same time period (assuming there are no errors in the price data).

Unfortunately, EMAs are not always as consistent as SMAs because of the way the EMA is calculated. The starting point matters. In theory, you need to use all the price data available for any individual stock. In practice, however, that is rarely done. Some charting software enables you to specify how much data is used when calculating an EMA, but most web‐based charting sites do not. The result: One charting vendor may calculate EMA values that differ from those provided by another.

Discovering that you’re basing your trading decisions on an inaccurate moving average is more than a bit disconcerting. This problem has less of an effect with short‐period calculations, but it’s especially problematic for longer‐term EMA calculations. For this reason, the EMA is commonly reserved only for shorter‐term periods. For example, many traders use three moving averages on their daily charts: a short‐term 20‐day EMA, an intermediate‐term 50‐day SMA, and a longer‐term 200‐day SMA.

Reaction time

In general, short‐term traders are more likely to employ EMAs, but position traders are more inclined to use SMAs. The EMA is usually closer to the current closing price, which tends to make it change direction faster than the SMA. As a result, an EMA is likely to be quicker in signaling short‐term trend changes. One of the most common EMA durations is the 20‐period. This is a popular moving average on daily charts.

The SMA is probably the better indicator for identifying long‐term changes in a trend. Unfortunately, those signals are likely to take more time to appear than the ones generated by a comparable EMA. The method used to calculate the SMA causes it to react to price changes a bit more slowly, and that’s the trade‐off for getting a signal that is potentially more reliable.

Sensitivity

An unfortunate result of the method of calculating an SMA is that every time you add a price, another price falls off the back end of the equation. In other words, each new SMA data point is affected by two prices, the most recent closing price and the oldest closing price in the calculation. Ideally, you want the most recent data to have a greater influence on your indicators than the older data. But with an SMA, the oldest price affects the newest SMA point with the same weight as the newest price.

EMA calculations eliminate that concern. Each data point affects the EMA only once. You never have to drop the oldest price as a new price is added. For that reason, the EMA has a much longer memory than the SMA. Every price ever used in calculating the EMA has some small effect. As an added benefit, EMA calculations place additional weight on the most recent price.