Using a moving average when price is displayed on a chart in a chaotic fashion with numerous jagged peaks and valleys (similar to a seismograph) provides the trader with an objective, clear picture of the direction the market is heading.
The use of a moving average allows traders to view the price action as a single fluid movement rather than looking at each individual candlestick. This enables them to identify trends, momentum and potential reversal points. When you complete this article, you will be able to differentiate the Simple Moving Average from the Exponential Moving Average; compare the two different types of Moving Averages to one another; understand the advantages and disadvantages of moving average crossover strategies; and comprehend why the 200-day moving average is considered a very significant technical indicator. Based upon these understandings, you should then be capable of selecting the most appropriate moving average strategy for your particular trading style.
Simple Moving Average
The simplest moving average (SMA) is the most basic type of moving average. It calculates an average of a specific number of closing prices over a given period. For example, if you wanted to calculate a 5-period SMA using closing prices of 10, 11, 12, 13, and 14; the total would be 60. Therefore, your 5-period SMA would be 12. As each new price bar appears on the chart, the oldest price bar drops off and the SMA moves forward.
The SMA (simple moving average) has equal weighting for each bar, which results in a smooth and slow-moving average. Therefore, the SMA is good at finding long-term trends and filtering out the noise of price action; however, it may provide you with late notice of a trend reversal. Position traders will want to use longer settings like 50 or 200 periods, while short-term traders using a 10 or 20 period SMA will find that it follows price action more closely.
Exponential Moving Average
An EMA, also known as an Exponential Moving Average, has a greater emphasis on current price action. To compute the EMA, you divide 2 by (the number of periods in your moving average + 1). As an example, if you are calculating a 10-period EMA, you would divide 2 by 11. This results in approximately 18.18%. To find the value for today’s EMA, you multiply the closing price for today with the result of the division, and add to that product the EMA from yesterday multiplied by (1 – the result of the division). Since most charting platforms automatically generate the EMA, you will not have to perform these calculations yourself.
An EMA reacts faster than an SMA with the same length when there are significant price increases or decreases. However, there will be more false signals with a faster moving average as well as reacting to smaller fluctuations. Many short-term traders are willing to make this trade off and often use the 9 or 21 period EMA.
EMA vs SMA
So which one is better – EMA or SMA (or SMA vs EMA)? Neither of them can win over each other since each address’s different types of questions. Here is a brief comparison of both:
Speed: the EMA reacts faster; the SMA reacts slower.
Smoothness: the SMA gives a cleaner line; the EMA is more sensitive.
Use the EMA for entries into trades and for identifying shorter-term trends; use the SMA to determine larger trends and support/resistance levels.
Figure 1: A 20-period SMA (navy) and a 20-period EMA (orange) follow the same synthetic prices. When prices surge, the orange EMA turns up first and hugs the price, while the navy SMA lags behind because every bar in its window counts equally. When prices roll over later, the EMA again reacts earlier. The illustration is synthetic and not market data.
Pick one style per timeframe and stay consistent. If you trade momentum, our guide to momentum trading and momentum strategies shows how traders pair averages with other signals.
Moving Average Crossovers
In the form of a single signal, the moving average crossover turns two lines into an indication of whether momentum is increasing or decreasing. A faster average crossing over a slower average indicates momentum is turning upward. A faster average crossing under a slower average indicates momentum is turning downward. Popular examples of this include the 9 EMA and 21 EMA for shorter-term trades and the 20 EMA and 50 EMA for swing trades.
Figure 2: This figure displays a synthetic price series with its 50-day Simple Moving Average (SMA) (orange) and 200-day SMA (navy). The teal dot indicates a “golden cross,” when the 50-day SMA goes higher than the 200-day SMA. The red dot indicates a “death cross,” when the 50-day SMA goes lower than the 200-day SMA. As you can see, each of these signals occur long after the actual reversal points, illustrating the lag that all moving averages have.
Crossovers are designed to be slow; therefore, you should utilize them for confirmation purposes instead of predictive. Crossovers perform well when there is a trend, however, they perform poorly in flat/sideways markets. Learn how to utilize charts to locate possible trading opportunities using indicators like “Breakouts,” as well as how to manage the risk involved in locating signals like those.
The 200-Day Moving Average
The 200-day moving average is what most people will use to determine the overall direction of the market. When the price of a stock moves above its 200-day moving average, it is generally considered to be a bullish sign and may indicate a long-term upward movement in the stock. If the price of a stock falls below its 200-day moving average, it is considered to be a bearish sign and indicates that the investor should proceed with caution. There are many investors, traders and funds that use this as a guide for their trading decisions; therefore, it can provide support when the price is moving higher and resistance when the price is moving lower. As such, a rapidly increasing 200 day moving average is a much stronger indicator of an upward trending market than a relatively flat 200 day moving average.
Figure 3: A created price series in relation to its 200-day Simple Moving Average (navy). Green shaded areas represent times when the price is above the moving average; teal-coloured dots indicate pullbacks that remained close to the moving average. Red shaded areas represent times when the price fell below the moving average and therefore reversed the trend filter. All data provided is for illustrative purposes only.
Think of the 200-day as a filter, not as an oracle. CMC Markets used an example of a “golden cross” that lost money. Do not trade based upon one indicator alone; use the line in conjunction with price action, market structure, and order flow.
Frequently Asked Questions About Moving Averages
Which is better, SMA or EMA?
I’m not sure if neither will be successful. While the exponential moving average (EMA) has a faster response time than the simple moving average (SMA), which means it can react quicker to changes in prices, and therefore is more useful for short-term trading, the SMA responds more slowly to changes in prices and thus is more useful for long-term trends. You should try both types of moving averages in your market and over your time frame.
What are the best moving average settings for day trading?
The magic number doesn’t exist for day trading. Most day traders use either the 9-day and 21-day EMA (exponential moving average), or they use only one 20-day EMA when trading on 1–15-minute time frames. Your use of these EMAs should be done in conjunction with your personal risk management strategy, as well as the trading concepts that are discussed in our Day Trading Strategies guide.
What is a golden cross and a death cross?
A golden cross is a positive signal that happens when the 50-day average moves higher than the 200-day average. A death cross is a negative signal that happens when the 50-day average drops below the 200-day average.
Do moving average crossovers give false signals?
Yes, especially when the price is moving horizontally (i.e. chopping above and below the moving average line). To confirm your findings, you should check for other factors such as trend, support/resistance levels, and/or volume. In addition to checking for these factors, you should always set a stop loss order.
Final Thoughts
The moving averages cannot tell us what lies ahead for the stock market. However, they can help us stay honest about how we view the trend at hand. Which moving average would you like to use first to test on your charts? Do you want to use the faster EMA (Exponential Moving Average) or the more stable SMA (Simple Moving Average)? We recommend that you test both of these in a demo account setting. Monitor which signals are reliable for you, and then adjust your settings accordingly. This content is for educational purposes only and does not constitute financial advice.
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