- The Simple Moving Average (SMA) is just the average of prices for X number of days
- We can use SMA to determine a change in uptrend and downtrend
- Exponential Moving Average (EMA) adds to SMA and weighs recent prices more than older prices in the calculation
Simple Moving Average (SMA) Identify Changes in Trend
A simple moving average (SMA) is the average price of the most recent X number of days. For example, a 2-day moving average would look like this: if the price is $100 today and $50 yesterday, then the simple moving average for today would be ($100 + $50 / 2 days) = $75.
Traders often use SMA as a signal to enter or exit a trade. When the faster SMA (2 days) crosses over the slower SMA (10 days), traders enter a trade. They believe that the trend is now changed because the more recent average price is greater than the longer period average price. The formula is listed here below:
We can also build on top of this concept and weigh the more recent prices more and the older prices less in our calculation. This in return creates the exponential moving average (EMA).
Exponential Moving Average (weighted) Is an SMA that Weighs Recent Prices More Than Older Prices
The EMA takes one more additional step and smooths the SMA. The most recent prices are weighted more, and the importance of price decreases the older it is. The formula allows the user to identify uptrends or downtrends in price while placing more importance on recent prices:
[Close – previous EMA] * (2 / n+1) + previous EMA
n=number of periods
Both tools are common within the stock trading community.