Moving averages are used to identify the direction of the trend and determine the support and resistance levels. There are two main types of moving averages, namely the simple moving average (SMA) and the exponential moving average (EMA).
MOVING AVERAGE ESSENTIALS
- Moving averages are popular indicators in technical analysis.
- They smooth out price action by filtering out short-term price fluctuations.
- They also help determine support and resistance levels.
- In terms of type, they are lagging indicators, and are used to confirm a pattern that is already in progress.
- There are two main types of moving averages:
- Simple moving average (SMA) calculates the arithmetical mean of an asset’s price over a number of time periods.
- Exponential moving average (EMA) takes into account SMA with an emphasis on recent price action. Thus, it lags behind the current price less than SMA.
Using moving averages
As they utilize sets of past prices, moving averages experience a certain period of lag. The more expansive a data set, the larger the lag. For instance, a moving average that takes into account the past 100 days will respond more slowly to new information than a moving average that only considers the past 10 days. This is because a new entry into a large data set has a smaller effect on the overall numbers.
Both large and small data sets can be beneficial – it all depends on the trading setup. Larger data sets benefit long-term investors. This is because they are less likely to be greatly altered due to one or two large fluctuations. Conversely, short-term traders normally prefer smaller data sets that facilitate more reactionary trading.
The most commonly used moving averages span over 50, 100 or 200 days. Traders keep a close watch on 50-day and 200-day moving averages. Any breaks above or below these lines are usually considered important trading signals, especially when followed by crossovers (moving averages with different time periods crossing each other). When a faster moving average crosses above a slower one, this is a bullish signal. The opposite is true for a bearish signal; a faster moving average crossing below the slower moving average.
Two types of crosses are particularly important. They are called the golden cross and the death cross. The golden cross happens when a 50-day moving average crosses above a 200-day moving average. The death cross occurs when a 50-day moving average crosses below a 200-day moving average. These two crosses signify a strong trend reversal in the market.
Calculating the simple moving average
The simple moving average (SMA) is determined according to the following formula, which calculates the arithmetical mean of an asset over a number of time periods:
A = closing price (sometimes open, high, etc.) in period n
n = number of time periods
Calculating the exponential moving average
The exponential moving average (EMA) is determined based on SMA according to the following formula:
A = current value (usually daily closing price)
s = smoothing (multiplier for weighting EMA; normally 2)
d = number of time periods (usually days)
SMA or EMA?
Due to its different calculation basis, EMA reacts to price changes sooner than SMA does. This is the key difference between the two types of moving averages, which does not necessarily make one better than the other.
Sometimes the EMA is better, as it can signal a trader to get in and out of the position more quickly, maximizing profits by buying at the lows and selling at the highs. However, these “lows and highs” could be only consolidation points in the market and the real trend reversal actually does not happen there. In this case, relying on the SMA would yield better results, as the trader would be compelled to stay in the position due to the slower curve reaction of the SMA.
Each trader must decide for themselves which moving average works better for their particular strategy. Many short-term traders prefer EMA, as they want to be alerted as soon as the price is moving in the opposite direction. Long-term traders normally rely on SMA since these investors do not rush to act and prefer to be less actively engaged in their positions.
To get the average of different types of moving averages, utilizing both SMA and EMA concurrently could give the best results.