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Moving averages are part of the common technical analysis that traders use to help them reach certain trading decisions. The average price is determined by moving averages over a period of time. They are called ‘moving’ because price movement adds new data to the calculation and changes the average. There are various ways to calculate averages, and we will look into the two most common ones – simple moving average (SMA) and exponential moving average (EMA).
Calculating SMA requires you to add the closing prices of days over a given time period, then divide by the days in the period. For example to calculate a seven-day SMA, add the closing prices of the last seven days and then divide by seven. New data is favored over old data where a seven-day average is recalculated by adding the new day and removing the first day, with the process continuing indefinitely.
Three steps are involved in calculating EMA, where recent prices are given more focus. Firstly, calculate SMA for initial EMA value as it has to start somewhere. Next, calculate the weighting multiplier with the formula [2/(N+1)] where N represents the time period. Finally, calculate the EMA of each day between initial EMA value and today, using the price, multiplier and previous period’s EMA.
EMA reacts quicker to price changes compared to SMA due to its calculation, but it isn’t necessarily better than the other. EMA reacts quickly and causes a trader to get out of a trade during a market hiccup while SMA keeps the trader in the trade, leading to a bigger profit when the hiccup is over. On the contrary, EMA alerts trouble quicker than SMA, so the trader can get out quicker, saving time and money.