The Moving
average is probably the most common used indicator in the trading world. It is
easy to understand and to calculate and therefore a good indicator to begin
with. Most traders put it on their charts without thinking about it. I think
that is a mistake, you should understand everything that is on your chart, or
it shouldn’t be there.
In this
article I will show how to calculate and use the Simple Moving Average (SMA)
and the Exponential Moving Average (EMA). They are similar but not equal.
Difference Between the SMA and the EMA
The SMA is
equally weighted, every price value has the same impact on the average. That is
not so for the EMA, where more weight is given to the more recent and less to
the older price data. That is why the EMA is called a weighted moving average.
This makes
the EMA more responsive to changes in price while the SMA is slower to react.
In turn this makes the SMA line smoother. Both have their advantages and
disadvantages as we will get to later.
Calculating the Simple Moving Average (SMA)
This is
probably the easiest calculation you will find in finance. You simply take the
average for the past n days and then move the average as they days go
by. If we want to calculate a three day moving average in Excel it would look
like this:
Calculating the Exponential Moving Average (EMA)
This is not
as straight forward as calculating the SMA. The formula for calculating the EMA
is:
With the
boring math formula out of the way, we can get on to the actual calculation.
But you may have noticed something: in the formula, EMA is used to calculate
the EMA! How can we plug in a value of the EMA into the formula when we are
trying to calculate the EMA?
Well, we
can’t, so we have two options. For the very first calculation, we can either
calculate the SMA of the previous n values or simply use the very first
price value. It really doesn’t matter since, when we move the average along
when we get the next price, this made up EMA is no longer used. Also, since it
is a weighted average, the first instance has the least impact.
Calculating
the three day EMA in Excel, using the SMA as the first “EMA value”, looks like
this.
Note how
the first calculation in cell D7 is different since it uses the SMA. The
smoothing factor is calculated in cell D2.
That is
about as much as I want to dive into the calculations. If you really want to
explore the mathematics of moving averages, then Wikipedia has all you need.
Links at the end of the article.
How to Use Moving Averages in Trading
Moving
averages are used to define trends, both long term and short term trends. Since
the EMA is more responsive to changes in price, it is generally more used by
short term traders, while the SMA, which is smoother is used by longer term
traders and investors. But that is a generalisation, either can be used for
both long and short term. I use only EMA since I only trade in the short term.
Strategies
using moving averages mostly involves “crossovers” of some kind. That could
either be when a faster moving average crosses a slower moving average. Or when
price crosses a moving average.
A fast
moving average is one with fewer days in the calculation. A moving average
using 10 days is more responsive to changes in price, or “faster”, than a 50
day moving average.
Example of a Crossover Strategy in FedEx
Entry: EMA10
crosses up above EMA20.
Exit: EMA10 crosses down below EMA20.
Here the
yellow EMA10 crosses line cross above the blue EMA20 line and the trade is
opened. When it crosses down below the EMA20 again, the position is closed.
This was a profitable trade but not a great one. There is plenty of lost
profits since it took a while for the EMA10 to cross down below again. If we
had used SMA10 and 20 it would have taken even longer for them to cross, and
the profit would have been even smaller.
Towards the
end of the chart there is another crossover when the price gaps up on positive
news. You would think that it would have been a wonderful trade, but it would
not. It is a little difficult to see, but what makes the EMA10 cross above is
the strong move up. So it would not have been possible to enter the trade at
the $255 level.
There are
other strategies however that would have entered the trade at $255-ish. But
that is for another article. Trading based only on SMA or EMA crossover is not
something that works in the long run. There are too many “false” signals when
the market isn’t in a clear up or downtrend.
Which Moving Average is Best?
Okey, we
have to ways of smoothing the price data, but which is better? Which one should
you use? The short answer is that it doesn’t matter since they differ very
little. Take a look at this chart of Dell with both the SMA10 and the EMA10
plotted.
The EMA10
is the yellow line and the SMA10 the purple. When the market gaps down, the
EMA10 reacts much faster since it gives the most emphasis to the last day of
the 10-day calculation. The equally weighted SMA10 is much smoother.
At the
beginning of the chart, when the market is in a clear uptrend, there is little
or no difference between the two. Is the faster EMA better since it is more
responsive? Not necessarily, it is all up to you hand how you trade the markets
that matter. The advantage with the slower SMA is that it cuts out a little
more market noise than the EMA.
Final
Thoughts
I use the
EMA since I think it makes sense to give less weight to older values. The
further back in time we go the less importance those value should have on
smoothing the data and find trends. I also like the fact that it reacts quickly
to price changes, that just suits my style of trading. The downside is that it
doesn’t cut out as much noise as the SMA.
But in all
honesty, I don’t think it matter which one you use as long as you pick one of
them and stick to it. Even for short term trading the SMA would work just as
fine. And the EMA for longer term trading as well.
A trading
strategy based only on moving average will not work in the long run. It will do
fine when the market goes from a period of sideways movement into a trend, but
when the market is in that sideways trading range, there will be too many false
signals as the averages will cross each other several times.
Moving
averages can be very useful together with other indicators, price and volume.
It is also common to scan for these crossovers on the various trading platforms
to alert of possible trades. When you have your list of crossovers, you do in
and check them one by one.
Finally, a
word of warning. There are an endless number of finance influencers on YouTube
trying to “sell” moving average crossover strategies with claims like; “99%
accuracy” or “the secret strategy they don’t want you to know about”. These
people are all scammers.
DON’T EVER
apply a strategy you have seen you YouTube or read about here on Medium, and
that includes any strategies of my own, if I ever decide to reveal one. You
must always understand the logic behind a strategy and test it thoroughly
before implementing it in the market with your own hard earned money.
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