In the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason. Moving averages smooth the price action and make it easier to spot underlying trends.
The most commonly used moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average (SMA)
The usefulness of the Simple Moving Average is questioned by some analysts since it takes into account only the period covered by the average (the last 9 days for example) and gives an equal weight to each days price.
So in a 9 day average, the last day's price is given the same weight as the first day's price, there is no additional importance placed on any of the day's prices. Some analysts believe that more weight should be placed on more recent prices and that is where the Exponential Moving Average comes in.
Exponential Moving Average (EMA)
The exponential moving average addresses the problems associated with the Simple Moving Average. It assigns a greater weight to the more recent price data and assigns less importance on the instrument's past price. Additionally, unlike the Simple Moving average that only takes into account the price data for the period covered by the average, the Exponential Moving Average takes into account all the price data in the life of the instrument.
The user of the Exponential Moving Average is also able to adjust the weighting to give more or less weight to the recent day's price.
Moving Averages as Trend Indicators
Precise trend signals can be obtained from the interaction between price and an average or between two or more averages themselves. Since the moving average is constructed by averaging several days' closing prices, it tends to lag behind the price action. The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action. A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes. The moving average is easily quantified and lends itself especially well to historical testing. Mainly for those reasons, it is the mainstay of most mechanical trend-following systems.
Commonly Used Moving Average Lengths
In stock market analysis, the most popular moving average lengths are 50 and 200 days. [On weekly charts, those daily values are converted into 10 and 40-week averages.] During an uptrend, prices should stay above the 50-day average. Minor pullbacks often bounce off that average, which acts as a support level. A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe correction. In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average. If a market is in a normal bull market correction, it should find new support around its 200-day average. [For short-term trading purposes, traders will employ a 20-day average to spot short-term trend changes.
Red: Simple Moving Average (SMA)
Blue: Exponential Moving Average (EMA)
Green: Smoothed Moving Average (SMMA)
Violet: Linear Weighted Moving Average (LWMA)