Moving averages are often used in investing to show the history of trends, especially stock prices. They allow investors to take a look at historical performance, smoothed out for any errant blips, and give a glimpse into where the stock price might go in the future. They can be used to find the resistance level in a rising market and the floor in a falling market. Simple and exponential are two types of moving averages, and both have different advantages over the other.
What is a Moving Average?
A moving average is a series of data points that shows the direction and velocity of numbers. A moving average is calculated by taking an average of several statistical points, then dropping the oldest and adding a new one for the next point on the graph to create a numerical movement over time.
Simple Moving Average
A simple moving average adds up a series of numbers and divides the total by the number of data points. For example, if calculating a 10-day average stock price, 10 days worth of stock prices will be added together and the result divided by 10. This provides the first data point. Then, the oldest day drops off and a new day is added and the formula applied again to result in the second data point. In this manner, the SMA is always moving forward toward the current date. It provides a smoothed historical stock price movement.
Exponential Moving Average
The exponential moving average modifies the SMA by giving more weight to more recent prices in the calculation. The purpose of this modification is to make the average more reflective of current stock price trends and ignore older ones. The EMA produces less of a lag time to reflect changing prices, especially in rapidly-moving stock values. The EMA starts with the SMA as its first data point, then applies a weighting factor to new data points to give them more relevance. The weighting factor depends on the number of data points in the series. For example, in a 10-day moving average, the weighting factor is 18.18 percent, rather than the 10 percent the new data point would be given in an SMA.
Advantages of SMA
There are advantages to both the SMA and the EMA, and both are often used together in stock analysis. While the EMA is useful because it does not lag as much as the SMA, the SMA has an advantage when trying to find support or resistance levels.The SMA shows a "true" average over time that smooths out any sudden or unusual price changes, whereas the EMA will follow the current price more closely, but is vulnerable to an unusual spike or drop in the recent prices.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.