Moving averages give traders an idea of the overall trend of a stock; they’re a technical indicator that can potentially reveal and provide trading opportunities.
To make the most of those opportunities, however, you have to know what you are looking at, and many investors think “moving average” refers to one thing. It doesn’t.
Differences between exponential and simple moving averages
There are two main types of moving averages: exponential and simple. The simple moving average takes the sum of the prices over a specified period and divides the total by the number of periods. For example, if you had five days of closing prices of $10, $10.50, $10.25, $10.75 and $10, the simple moving average would be calculated as ($10 + $10.50 + $10.25 + $10.75 + $10) / 5. Therefore, the simple moving average for this period would be $10.30.
Conversely, the exponential moving average has a slightly more complicated formula. With the exponential moving average, recent prices have a higher weight assignment, and the exponential weighted moving average requires the simple moving average to be calculated over a specified period. Moreover, a weighting multiplier is needed. We don’t need to get into all the math behind this indicator. The key takeaway: recent prices have a higher weight in exponential moving averages.
Here’s an example of a simple moving average:
In this daily chart on the SPDR S&P 500 ETF (SPY), notice the line plot, which gives an idea of the overall trend of the exchange-traded fund. This is the 50-day simple moving average, which is calculated using a rolling window. For example, the simple moving average price on June 20, 2017, ws calculated by taking the sum of the 50 trading days prior to that day, and dividing the total by 50.
On the other hand, here’s the 50-day exponential moving average of SPY:
At first glance, the simple and exponential moving average look identical. Look closely, however, and you’ll see that the exponential moving average follows the price action more closely. This is primarily due to the fact that the exponential moving average places a higher weight on recent price action.
Simple and exponential moving averages may seem identical, but there is a difference, namely that exponential moving averages follow the price action of stocks more closely than simple moving averages. They are harder to calculate, but it’s sometimes worth the additional math when you are using moving averages to analyze charts and trends.
Taylor Conway is the lead day trader at PennyPro.com. He is a short-term day trader of stocks and ETFs.