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Entering the realm of technical indicators, it’s easy to get lost in the jargon and the countless techniques available. As an introduction, we’re starting with the oldest and most widely used technical indicator. It also just happens to be the simplest - the moving average.

Moving averages are used in all financial markets. From stocks, options, forex, futures and crypto. They smooth out data to create a single flowing line that reveals predominant trends in the market. They use historical data to show price direction and are therefore considered lagging indicators.

There are two common moving averages. The Simple Moving Average (SMA) and the Exponential Moving Average (EMA). We examine both then discuss how to best incorporate moving averages into your trading strategy.

Simple Moving Average - SMA

Let’s first get acquainted with SMA. SMA is the most basic form of a moving average. It is quite simply the average price plotted on a price chart. For example, a 20 day SMA is the line constructed from the average of the last 20 days’ closing prices.

By taking the average, the SMA drowns out the noise from price outliers and volatility. This makes it easier to identify if a security is moving in an upward or downward trend.

The SMA applies equal weight to all observations in the time period. So on a 20 day SMA - The 20th day’s data carries the same weight as the first day.

Exponential Moving Average - EMA

The enhanced version of the SMA is the EMA. Unlike the SMA which places equal weight to all values, the EMA assigns greater significance to recent price observations. This allows the EMA to react faster to the latest changes in price data.

For example, if there has been a significant price drop in the last 2 days, an EMA will change direction before an SMA. This reduction in lag allows traders to quickly see if a trend is changing. Although, this feature also makes the EMA susceptible to premature price signals.

Calculating SMA & EMA

All popular trading platforms and charting interfaces will have tools that allow you to track moving averages. Nevertheless, it’s worthwhile to know how these moving averages are calculated to get a better understanding of how they function.

To calculate the EMA, you first need to compute SMA. The SMA uses the basic average calculation.

There are three steps to calculating the EMA.

1. Compute the SMA

2. Calculate the multiplier for weighting the EMA

3. Calculate the current EMA using the above formula

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