Here at Raging Bull, a lot of our gurus look at technical indicators. When you’re learning how to trade stocks, you need to focus on the basics first. Thereafter, you could move onto more advanced securities, such as options. You can’t learn how to trade options, if you don’t understand the basics of stocks first. Now, many traders use moving averages. If you’ve ever turned on CNBC, you’ve probably heard the talking heads say something like, “The stock just broke its 200-day moving average.” Well, when you’re learning how to trade stocks, you’ll need to know what people are talking about. Are they referring to the simple moving average (SMA) or the exponential moving average (EMA)? Here’s a look at the difference between the simple moving average and the exponential moving average.
How to Trade Stocks – SMA vs. EMA
The simple moving average assigns equal weighting to all values. For example, if you’re lookin at a 200-day SMA, the last 200 prices are summed up and divided by 200. Thereafter, you have your current 200-day SMA.
A lot of traders and investors use simple moving averages. They might use it to set their profit targets or stop prices. Now, let’s take a look at how to calculate the simple moving average.
For example, let’s say a stock’s last 10 closing prices were: $10, $10.50, $9.50, $11, $11.75, $11.25, $12.25, $12.10, $12.95, $12.35. To find the 10-day moving average based on closing prices, just add up all these prices and divide by 10. The 10-day moving average would be $11.365, or $11.37.
Generally, when you hear people talk about 20-, 50-, 100- or 200-day moving average, they’re referring to simple moving averages.
Now, the exponential moving average uses a different formula and a multiplier. You don’t really need to know how to calculate this indicator. Most charting software and brokerage firms already have this built in. All you need to know is that the exponential moving average places more weight on recent prices.
How to Trade Stocks – SMA vs. EMA Charts
Here’s a look at the iShares Russell 2000 ETF (IWM). We plotted the 13-period simple moving average (SMA) and the 30-period SMA on the hourly chart.
Now, Jeff Bishop likes to use simple moving average crossovers for his trading. Basically, if he sees the shorter-term SMA cross above the longer-term SMA, it’s a buy signal and he might buy shares of the stock or ETF, or even options on those securities. The opposite is true if the shorter-term SMA crosses below the longer-term SMA. A short-term moving average is said to be faster because it considers prices over short periods and are more reactive to daily price changes. On the other hand, longer term moving averages are thought to be slower because it filters out the noise in prices.
Moving on, here’s a look at the same chart, but with the 13-period exponential moving average (EMA) and the 30-period EMA.
Can you see the difference? There are some spots where the 13-hourly SMA crosses below the 30-hourly SMA, while the 13-hourly EMA does not cross below the 30-hourly EMA.
You could use SMAs and EMAs to signal when to buy penny stocks too. Basically, it could be used on all stocks, but you need to understand these are lagging indicators. In other words, they do not necessarily indicate where a stock is potentially headed.
Since more recent prices have higher weights, it responds more quickly to recent price changes. Many traders and investors like to use EMAs due to this fact. However, some traders still stick with SMAs because they found SMAs work better for their trading. Old habits die hard.
The Bottom Line
You should have a basic understanding of simple moving averages and exponential moving averages by now. However, just because you understand this, it doesn’t mean you’ll end up making money right away. Learning how to trade stocks is typically a long and bumpy road, but once you learn some of the fundamentals, you should start to get better over time. It’s going to require a lot of time, dedication and continuing education. There’s a lot to look forward to, because once you learn how to trade stocks, you could move on and learn how to trade options and potentially multiply your money.