|
SIMPLE VS.
EXPONENTIAL MOVING AVERAGES
A question about moving averages that seems to weigh
heavily on many swing traders' minds is whether to use the
"simple" or "exponential" moving average. Perhaps
because of its name, an exponential moving average sounds more
sophisticated or more elegant than the simple moving average. The simple
moving average may sound, perhaps, too simple.
What is the difference between the two? I provided you
with a calculation of the simple moving average in the first installment
of this series (you can find that discussion in our June
30th Swing Trader newsletter). A simple moving average is just an
arithmetic mean. If I wanted to calculate a 5-day simple moving average,
then I would just add the closing prices from the last five trading days
and would divide that figure by 5.
The exponential moving average is considerably more
complicated. The basic concept is that it weights the most recent price
data most heavily. The formula for the weighting of the current trading
day's value is 2 / (n+1), where "n" is the number of days in
the moving average. The result of this weighting is then added to the
previous exponential moving average calculation.
For example, let's say you were calculating a 10-day
exponential moving average. To the previous exponential moving average
figure you would add the weighting of 2 / (10 + 1), or 2/11, or .1818
times the current closing price. If you were working with a 20-day
moving average, then the calculation would be 2/21 or .095 times the
current close added to the previous exponential moving average. The
longer the period for which you calculate the moving average, the less
of an impact the exponential weighting has on the most recent data.
What is the purpose of the exponential moving average?
Moving averages are lagging indicators, and therefore, by definition,
will give late signals. By weighting recent price data more heavily,
exponential moving averages attempt to speed up the signal given. The
disadvantage of doing this, of course, is that this more-rapid signal
can sometimes be premature and therefore give the swing trader a false
indication to trade.
Does it matter, then, whether you use the simple or
exponential moving average in your chart analysis? For most practical
purposes, my answer to this question is "no." Below you will
find the same historical chart on McDATA (MDTA, $11.85) that I have used
previously in this newsletter.
On this chart, I have put both the simple and
exponential moving averages for the 4, 30 and 50-day periods. Note how
close these averages are to one another. The 4-days are at $7.03 and
$7.04. The 30-days are at $7.73 and $7.39 and the 50-days are at $7.46
and $7.44. There is a reasonable percentage difference in the two 30-day
moving averages. However, when price crossed below the rising 30-day
moving averages in early December, providing a valuable trading signal,
these averages were very close to one another. The cross took place on
the same trading day no matter whether you used the simple or
exponential moving average. Therefore, no matter which average you used,
you would have received the same signal. While one case does not prove a
point, in almost all the tests I've tried, the same result has occurred.
So, my best advice would be for you to choose whichever type of average
you are most comfortable with it and then apply it consistently to the
charts you analyze.
This discussion of simple vs. exponential moving
averages concludes our multi-part discussion of this valuable trading
tool. Here are a number of important principles to keep in mind when you
apply moving averages to your swing trading:
- A moving average is a curved trendline line. Moving
averages are lagging, or trend-following, indicators. They provide
support and resistance.
- Always pay close attention to the slope of the
moving average. An upward-sloping moving average is more bullish
than one that is sloping sideways. A downward-sloping moving average
is more bearish than one that is moving sideways.
- A bullish signal is present when the share price is
above an upward-sloping moving average. A bearish signal is present
when price is below a downward-sloping moving average. If you are
using more than one moving average on a chart, then it is bullish if
the shorter moving average is above the longer one and the share
price is above both moving averages. It is bearish when the reverse
is true.
- There is no one "right" moving average
(or combination of moving averages, for that matter) to use. A 4-day
moving average when combined with a 9-day will give very similar
signals to a 5-day combined with a 10-day. Simple and exponential
moving averages will often give similar readings. Find moving
averages you are comfortable with and then apply them consistently.
- Apply moving averages that allow you to analyze the
chart in the short, intermediate and primary time frames. My choice
for these moving averages are 4 and 9-day for short term, 20, 30 and
50-day for intermediate term, and 150, 200-day for long term.
- The moving averages are in "bullish"
alignment when all (or nearly all) are above one another and price
is above all of them. They are in bearish alignment when the reverse
is true.
- Crossovers of moving averages provide important
trading signals. For swing traders, the 4, 9 and 18 or 20-day moving
averages give important trading signals. Considering buying long,
depending on other chart messages, when the 4-day crosses above the
9-day, which then crosses above the 18-day. Considering selling
short when the 4-day crosses below the 9-day and the 9-day then
crosses below the 18-day. Note the relation of these moving averages
to the 150 or 200-day moving average when you get the signal to see
how far the move might carry the stock.
For me, moving averages are one of the most powerful
trend-following tools available to the swing trader. However, they
should not be used in isolation. Instead, you should use moving averages
in conjunction with price pattern analysis, candles, and indicators such
as MACD and stochastics to create powerful and profitable chart
analysis.
|
|
