A moving average is an average of data points (usually price) for a specific time period. Why is it called “moving”? That’s because each data point is calculated using data from the previous X periods. Because it averages prior data, moving averages smooth the price data to form a trend-following indicator.
A moving average doesn’t predict price direction. Instead, it defines the current direction. However, a moving average tends to lag because it’s based on past prices. Despite this, investors use moving averages to help smooth price action and filter out the noise.
Exponential Moving Average (EMA) is similar to Simple Moving Average (SMA), measuring trend direction over a period of time. However, whereas SMA simply calculates an average of price data, EMA applies more weight to data that is more current.
- The exponential moving average gives a higher weighting to recent prices.
- The simple moving average assigns an equal weighting to all values.
- As with all technical indicators, there is no one type of average a trader can use to guarantee success.
Exponential Moving Average vs. Simple Moving Average: An Overview
Exponential Moving Average (EMA) and Simple Moving Average (SMA) are similar in that they each measure trends. The two averages are also similar because they are interpreted in the same manner and are both commonly used by technical traders to smooth out price fluctuations.
There are some differences between the two measurements, however. The primary difference between an EMA and an SMA is the sensitivity each one shows to changes in the data used in its calculation.
SMA calculates the average of price data, while EMA gives more weight to current data. The newest price data will impact the moving average more, with older price data having a lesser impact.
More specifically, the exponential moving average gives a higher weighting to recent prices, while the simple moving average assigns equal weighting to all values.
The SMA is used to identify the longer-term trend and potential areas of support or resistance, while the shorter-term EMA, also called the signal line, will be used to identify potential changes in the trend for buying or selling opportunities.
Starting in the upper left and following along with the numbers above:
- Point 1: We see the more sensitive EMA cross under the longer-term SMA signaling a potential change from an uptrend to a downtrend. This would be a place where a trader may look to execute a sell order to establish a short position.
- Points 2, 3 and 4: As the market drops, we look to the longer-term SMA as an indication of potential resistance from prices climbing higher and the downtrend continuing. As you can see there were multiple times where price rose up, touched the 60 period SMA, but could not break through and was pushed lower.
- Point 5: Price finally breaks through and the next candles close above the SMA. Shortly after, the EMA crosses above the SMA signaling a potential change from a downtrend to an uptrend. In this area, traders would exit their sell positions and may choose to reverse with a buy order to establish a long position.
Key takeaways
SMA and EMA are useful for traders when establishing a trend and working out entry points. Both have their own strengths and can be used alongside other technical indicators to give traders a clearer picture.
The two main things to remember are:
- SMA = simple moving average. It is most useful as a long-term indicator.
- EMA = exponential moving average. It is most useful as an indicator where short-term price movement is more relevant.
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