Types of Moving Averages
The most popular moving averages are the: simple, exponential and weighted moving averages. There are others like the triangular, Wilder’s Smoothing, end point and time series, but they are beyond the scope of this article and are not of particular interest to most traders because of their tendency to introduce a lot of noise into the indicator. Here are the three that are generally considered to be the best moving averages for trading stocks:
Simple: A simple moving average (SMA) measures the average price over a specific time frame. For example, a 5-day simple moving average is the sum of the last 5 days closing/opening price divided by the number of time periods (5). In essence, simple moving average gives equal weighting to all periods in the sample data.
Although you can use more time periods in the moving average, the more periods that are included in the analysis, the less emphasis there is on the more recent trading action. This happens because a simple moving average gives equal weight to each trading period, which causes SMA to respond slowly to price fluctuations; this is why it is referred to as a lagging indicator.
Exponential: Traders tend to prefer the exponential moving average (EMA) because it is faster than the SMA in responding to the latest price action. Exponential moving averages have less lag because they put more weight on the most recent prices. As a result, they will more quickly, confirm a change in the market’s trend or signal a trade entry than would a SMA. Consequently, traders regard EMA as the best moving average for short-term trading.
While it is true that the exponential moving average is faster than the simple moving average, one must remember that it can also cause more false entry and exit signals.
Weighted: This is another flavor of the exponential moving average but it gives even more weight to more recent prices to make the technical analysis indicator faster. This introduces more noise than the simple and exponential moving averages but it is quicker at confirming trades.