SMA vs. EMA

Even though there are clear differences between simple moving averages and exponential moving averages, one is not necessarily better than the other. Exponential moving averages have less lag and are therefore more sensitive to recent prices and recent price changes. The simple moving average may sound, perhaps, too simple. The exponential moving average is considerably more complicated. The basic concept is that it weights the most recent price data most heavily.

Moving averages are lagging indicators, and therefore, by definition, will give late signals. By weighting recent price data more heavily, exponential moving averages attempt to speed up the signal given. The disadvantage of doing this, of course, is that this more-rapid signal can sometimes be premature and therefore give the swing trader a false indication to trade. Simple moving averages, on the other hand, represent a true average of prices for the entire time period. As such, simple moving averages may be better suited to identify support or resistance levels.

Moving average preference depends on objectives, analytical style and time horizon. Chartists should experiment with both types of moving averages as well as different time frames to find the best fit. Below Chart shows IBM with the 50-day SMA in red and the 50-day EMA in green. Both peaked in late January, but the decline in the EMA was sharper than the decline in the SMA. The EMA turned up in mid February, but the SMA continued lower until the end of March. Notice that the SMA turned up over a month after the EMA.

Which moving average you use will depend on your trading and investing style and preferences. Some traders prefer to use exponential moving averages for shorter time periods to capture changes more quickly. Some investors prefer simple moving averages over the duration of long time periods to identify long-term trend changes. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.

Ultimately, it comes down to your experience and even the character of a given security – some tend to ‘work’ better with SMAs while others do so with EMAs – it takes practice and experience to find the balance that works for you. A 50-day SMA might work great for identifying support levels in the NASDAQ, but a 100-day EMA may work better for the Dow Transports, for instance. Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past.

Exponential Moving Average (EMA)

This moving average calculation uses a smoothing factor to place a higher weight on recent data points. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. As you can see in figure above, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesn’t seem like much, but it is an important factor to be aware of since it can affect returns.

The exponential moving average has been refined and more commonly used since the 1960s, thanks to earlier practitioners' experiments with the computer. The new EMA would focus more on most recent prices rather than on a long series of data points, as the simple moving average required.

EMA Calculation

Exponential moving averages reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average. There are three steps to calculating an exponential moving average. First, calculate the simple moving average. An exponential moving average (EMA) has to start somewhere so a simple moving average is used as the previous period's EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the exponential moving average. The formula below is for a 10-day EMA.

SMA: 10 period sum / 10

Multiplier: (2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)

EMA: {Close - EMA(previous day)} x multiplier + EMA(previous day).

A 10-period exponential moving average applies an 18.18% weighting to the most recent price. A 10-period EMA can also be called an 18.18% EMA. A 20-period EMA applies a 9.52% weighing to the most recent price (2/(20+1) = .0952). Notice that the weighting for the shorter time period is more than the weighting for the longer time period. In fact, the weighting drops by half every time the moving average period doubles.