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.
FAQs
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 reversal points.
What are the advantages and disadvantages of the moving average method? ›
Hence, a moving average cannot show the constant changes in their prices. The primary purpose of identifying a trend is to predict the future values of the stock. But, if the security does not trend up or down, calculating moving averages will not be able to provide the traders with an opportunity to profit.
What is the main disadvantage of the moving average? ›
The disadvantages of moving average analysis center around its simplicity and subjective flexibility.
What are the advantages and disadvantages of EMA? ›
EMA provides higher weights to recent prices, while on the other hand, SMA gives equal weights to all values. Also, EMA is used for shorter time periods and fast-moving markets and SMA is used when a trader is holding a certain position for a long period of time.
What is the primary advantage of the simple moving average methods? ›
Analytical Significance. Moving averages are an important analytical tool used to identify current price trends and the potential for a change in an established trend. The simplest use of an SMA in technical analysis is using it to quickly determine if an asset is in an uptrend or downtrend.
What are the advantages and disadvantages of simple average method? ›
This method is more benefited than FIFO and LIFO, if there is very small fluctuation in the buying prices. Major disadvantages of simple average method are as follows: 1. If the quantity in each lot varies widely, the average price will lead to erroneous costs.
What are the disadvantages of simple average method? ›
Following are the disadvantages of simple average method. i) Materials are not priced at actual costs. ii) It does not take into account the quantity of materials purchased. iii) Verification of closing stock becomes difficult.
What is the problem with simple moving average? ›
There is one problem with the simple moving average: they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new currency trend may be developing but in reality, nothing changed.
What is the difference between simple and moving average? ›
The exponential moving average gives a higher weighting to recent prices. The simple moving average assigns an equal weight to all values. As with all technical indicators, a trader cannot use one type of average to guarantee success.
What are the disadvantages of using EMA? ›
Limitations of EMA
It is more time consuming for the research subject than meeting with a clinician at intervals. Another disadvantage of EMA, as with all self-report measures, is that there is no independent check on the veracity of the data, because all data are collected in the absence of the experimenter.
The MA model is great because it's computationally efficient and yields a very stable forecast, in that it doesn't change drastically from one value to another. In addition, an MA model can be updated every time a new forecast is made; that is, you add in the forecast errors and update the model.
What are the advantages of moving average forecasting? ›
In the case of time series data, Moving Average forecasts are often used to eliminate unwanted fluctuations, thereby smoothing the time series. The appropriate number of preceding periods is determined by selecting the number of periods that yields the least amount of error.
Why use a simple moving average? ›
The SMA, with its built-in lag, tends to smooth price action over time, making it a good trend indicator—staying long when price is above the average and flat (or short) when it's below. A simple moving average can also be effective as a support and resistance indicator.
What is the SMA moving average? ›
A simple moving average (SMA) is a technical indicator that's calculated by adding the closing price of a stock or other security over a specific period of time and dividing the total by the appropriate number of trading days. For example, a 20-day SMA is the average closing price over the previous 20 days.
Is simple moving average positive or negative? ›
The SMA signal receives two values, either positive when the shorter-term SMA is above the Longer-term or negative when the shorter-term SMA is below the longer term.
What are the benefits of moving averages? ›
The reason for calculating the moving average of a stock is to help smooth out the price data by creating a constantly updated average price. By calculating the moving average, the impacts of random, short-term fluctuations on the price of a stock over a specified time frame are mitigated.
What are the problems with moving average method? ›
Moving averages can be spread out over any time period and this can be problematic because the general trend can be different depending on the time period used.
Which of the following is are disadvantages of the moving average forecast? ›
Which of the following is / are disadvantages of the moving average forecast? It is difficult to compute. Random variations are smoothened out, making structural patterns less evident. Potential loss of information of less recent values by decreasing the number of values.
