Moving averages are used to pinpoint trade areas, to identify trends, and to analyze markets. Moving averages help traders isolate the trend in a security, or the lack of one, and can also signal when a trend may be reversing. Two of the most common types are simple and exponential. We will look at the differences between these two moving averages.
Simple Moving Average
To calculate a 10-day simple moving average (SMA), add the closing prices of the last 10 days and divide by 10. To calculate a 20-day moving average, add the closing prices over a 20-day period and divide by 20.
For example, given the following series of prices:
$10, $11, $11, $12, $14, $15, $17, $19, $20, $21
The SMA calculation would look like this:
$10+$11+$11+$12+$14+$15+$17+$19+$20+$21 = $150
10-day period SMA = $150/10 = $15
Exponential Moving Average
The exponential moving average (EMA) focuses more on recent prices than on a long series of data points, as the simple moving average required.
The most important factor is the smoothing constant that = 2/(1+N) where N = the number of days.
A 10-day EMA = 2/(1+10) = 0.1818
For example, a 10-day EMA weights the most recent price at 18.18 percent, with each data point after that being worth less and less. The EMA works by weighting the difference between the current period’s price and the previous EMA and adding the result to the previous EMA. The shorter the period, the more weight applied to the most recent price.