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.
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.
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.
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 of the simple moving average? ›
One of the main benefits of using moving averages is their ability to filter out market fluctuations and provide a clearer picture of the underlying trend. This can help traders avoid getting caught up in short-term price fluctuations and focus on the market's overall direction.
What are the disadvantages of the simple average method? ›
Disadvantages Of Simple Average Method
1. If the quantity in each lot varies widely, the average price will lead to erroneous costs. 2. Costs are not fully recovered.
What are the pros and cons of moving averages? ›
Unlike trying to track a stock price day-to-day, a moving average smooths price volatility and is an indicator of the current direction a price is headed. A moving average reflects past prices — usually a stock's closing price — so it's not a predictor of future direction, just what's happening now or in the past.
What is the primary disadvantage of the moving average method? ›
The predicted values here do not follow a certain pattern like linear or curvilinear. For this reason, the future values cannot be calculated by extending those patterns.
What are the advantages of SMA? ›
The benefits of investing in an SMA include personalized portfolio management, greater transparency, direct ownership of assets, potential tax efficiency, and the ability to exclude certain investments based on personal preferences or ethical considerations.
What are the advantages and disadvantages of average? ›
Advantage 2: Easy to work with and use in further analysis. Disadvantage 1: Sensitive to extreme values. Disadvantage 2: Not suitable for time series type of data. Disadvantage 3: Works only when all values are equally important.
What are the disadvantages of SMA? ›
The SMA's weakness is that it is slower to respond to rapid price changes that often occur at market reversal points. The SMA is often favored by traders or analysts operating on longer time frames, such as daily or weekly charts.
What is the problem with simple moving average? ›
If the data used are not centered around the mean, a simple moving average lags behind the latest datum by half the sample width. An SMA can also be disproportionately influenced by old data dropping out or new data coming in.
Is SMA a good indicator? ›
SMA is one of the core indicators in technical analysis and is usually the easiest moving average to construct. The aim of all moving averages is to establish the direction in which the price of a security is moving based on previous prices. Since SMA is constructed using past closing prices, it is a lag indicator.
Limitations of Simple Moving Average
It is unclear whether or not more emphasis should be placed on the most recent days in the time period or on more distant data. Many traders believe that new data will better reflect the current trend the security is moving with.
What happens if you are using a simple moving average? ›
It is simply the average price over the specified period. The average is called "moving" because it is plotted on the chart bar by bar, forming a line that moves along the chart as the average value changes. SMAs are often used to determine trend direction. If the SMA is moving up, the trend is up.
What are the disadvantages of simple average of price relative method? ›
(I) The items with large unit prices have greater influence on the index. (II) No weightage is given to the relative importance of the items.
What are the advantages of using simple average cost method? ›
The main benefit of the average-cost method is its simplicity, particularly for companies that deal with large volumes of very similar items. Rather than tracking each item and its individual cost, these figures can be averaged.
Why are simple moving averages beneficial to investors? ›
This essentially “smooths out” price fluctuations to give an investor a general idea where the trend is heading. Using simple moving averages to determine trends, an investor can better identify buy and sell signals.
What are the advantages and disadvantages of moving average filter? ›
2 Moving average filter. Averaging on a signal actually is equivalent to smoothing done on a signal or performing a low-pass filtering on a signal. The main advantage of using MA is the simplicity of the algorithm, and main disadvantage is the loss of information if M is increased a lot.
