A simple moving average (SMA) is a chart indicator that helps traders see trends and identify key price points for a stock, commodity, forex pair, exchange traded fund, or futures contract. The indicator is computed as an average of prices over a specific period of time, such as 20, 50, or 200 days. Critics argue that a simple average gives too much weight to old data, which are deemed to be less significant. Therefore, many traders prefer to use an exponential moving average (EMA) instead.
Key Takeaways
- A simple moving average is a chart indicator that is computed as the average of closing prices over a period of days, like 50 or 200 days.
- Some traders believe that a simple moving average gives too much weight to old data and prefer to use an exponential moving average instead.
- SMAs and EMAs are used in similar ways: to identify trends and find potential areas of support or resistance.
- An advantage of the SMA is that is smooth, but a disadvantage is that it might not accurately reflect the most recent trends.
SMA vs. EMA
The SMA is a straightforward calculation because the indicator is simply the average price over a chosen time period. For example, if a stock closes at $50, $51, and $52 over three days, the three-day moving average is plotted at $51 per share. As each new day is added, an old one drops off.
A simple moving average provides insight into trends and potential support or resistance areas. The SMA typically trends higher when prices move up and lower as prices turn to the downside. In an uptrend, a simple moving average often appears below price and, when price falls toward the SMA (but not below it), the average identifies a potential area of support. On the other hand, when the simple moving average is above price in a downtrend, the SMA slopes downward and sometimes appears as an area of resistance.
In contrast to the simple moving average, the exponential moving average is computed in a manner that gives greater weighting to the most recent days. That is, the EMA takes a simple moving average and uses a multiplier so that more recent data is assigned more importance. The calculation typically follows the formula: [2 ÷ (selected time period + 1)]. For example, the multiplier on a 20-day moving average is [2/(20+1)]= 0.0952.
Advantages and Disadvantages
The main advantage of the SMA is that it offers a smoothed line, less prone to whipsawing up and down in response to slight, temporary price swings back and forth. The SMA's weakness is that it is slower to respond to rapid price changes that often occur at market reversalpoints. The SMA is often favored by traders or analysts operating on longer time frames, such as daily or weekly charts.
The advantage of the exponential moving average is that by being weighted to the most recent price changes, it responds more quickly to price changes than the SMA does. This is particularly helpful to traders attempting to trade intraday swing highs and lows since the EMA signals trend change more rapidly than the SMA does.
The concurrent disadvantage of the greater sensitivity of the EMA is that it is more vulnerable to false signals and getting whipsawed back and forth. The EMA is commonly used by intraday traders who are trading on shorter time frames, such as the 15-minute or hourly charts.
The Bottom Line
The advantage of the simple moving average is that the indicator is smoothed and, compared to the EMA, less prone to a lot of false signals. The drawback is that some of the data used to compute the moving average might be old or stale. Nevertheless, the EMA and SMA are used in similar ways: to see trends and identify areas of support or resistance. Since neither average is inherently superior, the question of which one to use is typically settled by the user's trading style or analytical frame of reference.
FAQs
The main advantage of the SMA is that it offers a smoothed line, less prone to whipsawing up and down in response to slight, temporary price swings back and forth. The SMA's weakness is that it is slower to respond to rapid price changes that often occur at market reversal points.
What are the advantages and disadvantages of SMAs? ›
The advantages of SMAs include customization, direct ownership of shares, transparency, and reduced capital gains tax.
- Customization. ...
- Direct Ownership of Shares. ...
- Transparency. ...
- Reduced Capital Gains Tax. ...
- Complicated Fee Structure. ...
- High Investment Minimums. ...
- Intensive Work. ...
- Investment Performance.
Analytical Significance. Moving averages are an important analytical tool used to identify current price trends and the potential for a change in an established trend. The simplest use of an SMA in technical analysis is using it to quickly determine if an asset is in an uptrend or downtrend.
What is the primary disadvantage of the moving average method? ›
Demerits of Moving Averages
Since each stock or commodity has its unique price history, no set rules can be implemented across all markets. Hence, a moving average cannot show the constant changes in their prices. The primary purpose of identifying a trend is to predict the future values of the stock.
What are the advantages of moving average model? ›
Moving averages help smooth time series and identify the data components used in a statistical model. Smoothing is the process of eliminating random variations that are coarser in plotted time series data. In this case, minimizing noise helps highlight signals that contain trends and cycle occurrences.
What are the disadvantages of SMA? ›
The SMA's weakness is that it is slower to respond to rapid price changes that often occur at market reversal points. The SMA is often favored by traders or analysts operating on longer time frames, such as daily or weekly charts.
What are the benefits of SMA? ›
What tax advantages do SMAs offer?
- More opportunities to harvest losses. ...
- No embedded capital gains for SMAs. ...
- Greater control over your tax bill. ...
- Choosing an SMA for your portfolio.
There is one problem with the simple moving average: they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new currency trend may be developing but in reality, nothing changed.
What is the primary advantage of the simple moving average method Chegg? ›
What is the primary advantage of the simple moving average methods? The weights are not equally distributed across every period. It can forecast without a prior data. It is quick, easy, and simple.
What is the primary advantage of the simple moving average methods Quizlet? ›
The main advantage that simple moving-average models have over exponentially-smoothed models is that they can be made to give any desired weight to specific periods in the past.
This method is more benefited than FIFO and LIFO, if there is very small fluctuation in the buying prices. Major disadvantages of simple average method are as follows: 1. If the quantity in each lot varies widely, the average price will lead to erroneous costs.
What are the disadvantages of simple average method? ›
Following are the disadvantages of simple average method. i) Materials are not priced at actual costs. ii) It does not take into account the quantity of materials purchased. iii) Verification of closing stock becomes difficult.
Why use a simple moving average? ›
The SMA, with its built-in lag, tends to smooth price action over time, making it a good trend indicator—staying long when price is above the average and flat (or short) when it's below. A simple moving average can also be effective as a support and resistance indicator.
What are the disadvantages of moving average in time series? ›
However, two drawbacks are that Moving Averages do not effectively handle significant trends in data, and all Historical data must be stored to create the Moving Average. In the case of time series data, Moving Average forecasts are often used to eliminate unwanted fluctuations, thereby smoothing the time series.
What is the main advantage of using a moving average model for time series forecasting? ›
Moving average smoothing
Observations that are nearby in time are also likely to be close in value. Therefore, the average eliminates some of the randomness in the data, leaving a smooth trend-cycle component.
Are Fidelity SMAs worth it? ›
SMAs offer a high degree of transparency because you can track individual positions and prices intraday and can also provide individualized tax management. Unlike mutual funds or ETFs, SMAs can be customized: You can pick a limited number of investments to exclude.
What are the disadvantages of an asset management account? ›
Disadvantages of asset management
- You may be able to reach your investment or savings goals without any outside help, using traditional savings products, like ISAs.
- Many asset managers require a minimum level of investment, which could be more than you're looking to invest.
Direct ownership—Investors in SMAs own the individual securities in their portfolio, providing the opportunity for enhanced tax planning and customization. Fees can be lower—SMAs have a more efficient underlying structure that may be less expensive than mutual funds.
What are the disadvantages of shape memory alloys? ›
Disadvantages of Shape Memory Alloys
They have poor fatigue properties. They are expensive. They have low energy efficiency.
