A simple moving average (SMA) is a chart indicator that helps traders see trends and identify key price points for a stock, commodity, forex pair, exchange traded fund, or futures contract. The indicator is computed as an average of prices over a specific period of time, such as 20, 50, or 200 days. Critics argue that a simple average gives too much weight to old data, which are deemed to be less significant. Therefore, many traders prefer to use an exponential moving average (EMA) instead.
SMA vs. EMA
The SMA is a straightforward calculation because the indicator is simply the average price over a chosen time period. For example, if a stock closes at $50, $51, and $52 over three days, the three-day moving average is plotted at $51 per share. As each new day is added, an old one drops off.
Key Takeaways
- A simple moving average is a chart indicator that is computed as the average of closing prices over a period of days, like 50 or 200 days.
- Some traders believe that a simple moving average gives too much weight to old data and prefer to use an exponential moving average instead.
- SMAs and EMAs are used in similar ways: to identify trends and find potential areas of support or resistance.
- An advantage of the SMA is that is smooth, but a disadvantage is that it might not accurately reflect the most recent trends.
A simple moving average provides insight into trends and potential support or resistance areas. The SMA typically trends higher when prices move up and lower as prices turn to the downside. In an uptrend, a simple moving average often appears below price and, when price falls toward the SMA (but not below it), the average identifies a potential area of support. On the other hand, when the simple moving average is above price in a downtrend, the SMA slopes downward and sometimes appears as an area of resistance.
In contrast to the simple moving average, the exponential moving average is computed in a manner that gives greater weighting to the most recent days. That is, the EMA takes a simple moving average and uses a multiplier so that more recent data is assigned more importance. The calculation typically follows the formula: [2 ÷ (selected time period + 1)]. For example, the multiplier on a 20-day moving average is [2/(20+1)]= 0.0952.
Advantages and Disadvantages
The main advantage of the SMA is that it offers a smoothed line, less prone to whipsawing up and down in response to slight, temporary price swings back and forth. The SMA's weakness is that it is slower to respond to rapid price changes that often occur at market reversalpoints. The SMA is often favored by traders or analysts operating on longer time frames, such as daily or weekly charts.
The advantage of the exponential moving average is that by being weighted to the most recent price changes, it responds more quickly to price changes than the SMA does. This is particularly helpful to traders attempting to trade intraday swing highs and lows since the EMA signals trend change more rapidly than the SMA does.
The concurrent disadvantage of the greater sensitivity of the EMA is that it is more vulnerable to false signals and getting whipsawed back and forth. The EMA is commonly used by intraday traders who are trading on shorter time frames, such as the 15-minute or hourly charts.
The Bottom Line
The advantage of the simple moving average is that the indicator is smoothed and, compared to the EMA, less prone to a lot of false signals. The drawback is that some of the data used to compute the moving average might be old or stale. Nevertheless, the EMA and SMA are used in similar ways: to see trends and identify areas of support or resistance. Since neither average is inherently superior, the question of which one to use is typically settled by the user's trading style or analytical frame of reference.
