In the previous lessons, you walked through the two main types of moving averages – the simple and exponential moving averages.
As trend-following indicators, both moving averages factor in historical prices to determine the potential market price movement. However, how do these two moving averages compare to one another?
In this lesson, you’ll look at the simple and exponential moving averages side by side to effectively pinpoint which is which. After reading this lesson, you’ll determine which of the two MAs is better.
At the start of this module, you were introduced to the concept of moving averages. Being familiar with moving averages is important to fully realize the concept of simple and exponential moving averages.
At its core, moving averages (MA) help traders to accurately analyze the forex market by smoothing out price data. A trader using MA considers the historical prices of an asset (predetermined period) to get the average price point at which the asset moves.
You know that the forex market is noisy – it moves from time to time, often distorting the underlying trend. However, analyzing the market with MA mitigates such noise from affecting your findings.
Read more: TradersUnited – Forex Moving Averages Explained
Simple and exponential moving averages are the two primary MA indicators.
Both Moving Averages provide profitable entry/exit points, identify prevailing trends, and remove unnecessary and random price movements. However, the two are greatly different from one another as well.
Here are the three primary differences between simple and exponential moving averages.
The major difference between the two is the sensitivity or adaptability of price changes.
Considering forex’s volatile nature, currency pairs’ prices change randomly and abruptly.
However, SMA’s broad consideration of historical price data makes the indicator unreactive to abrupt market events and movements.
On the flip side, EMA puts more weight on the most recent price data to ensure the reliability of the price’s moving averages.
Being sensitive to price changes is naturally good. However, it could signal premature entry/exit points due to sensitive price reactions. This is truer when the market consolidates, retraces, or fakes out.
To prevent falling to such false signals, remember to always employ multi-indicator analysis to confirm the signal.
No indicator should be treated as self-confirming.
Another difference between the two moving averages is their approach to determining the MA values.
Getting the asset’s Simple Moving Averages (SMA) is straightforward – just determine a period of analysis, get each period’s closing prices, get the sum, and divide it by the total number of periods.
Simple Moving Average = A1 + A2 + ... + An
On the other hand, the Exponential Moving Average (EMA) calculation is far more complex than the SMA. In fact, it requires traders to undergo three steps just to get EMA:
Exponential Moving Average = (closing price – previous day’s EMA) x multiplier + previous day’s EMA
EMA shows the most recent and relevant moving averages, while SMA considers a broader market movement by factoring in all price data over the specified period.
Read more: TradersUnited – The Basics of Exponential Moving Averages (EMA)
Like any technical indicator, both SMA and EMA are susceptible to providing false signals. This drawdown is typically driven by the dynamic nature of the financial markets.
To prevent trading false signals, traders typically employ multi-indicator analysis to draw out a better and more informed perspective of the underlying trend.
For moving averages, indicators that suggest price actions and trend strength can be used to supplement findings and confirm signals. This includes the following:
EMA is considered a faster lagging indicator compared to SMA’s slow lag.
As a rule of thumb, short-term traders like scalpers and day traders should use an indicator that’s safe and profitable in a short-term trending environment.
With this, EMA should be used for short-term trading.
However, EMA’s sensitivity to price changes makes this MA type ineffective for longer-term trading. It’s because your position would prematurely enter or exit the market without realizing the major trend.
Thus, a slower lagging indicator like SMA is ideal when analyzing a long-term asset movement. SMA eventually smoothens the price action – making it a valuable indicator of market trends while keeping the position open and profitable in the market.
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