When carefully scrutinizing a stock or exchange traded fund chart, investors often follow the moving average as a valuable tool in guiding an investment strategy. However, investors may have noticed the slight variation between the simple and exponential moving averages.
The simple moving average (SMA) is the average price of a security over a specific period. For instance, the 50-day moving average is calculated by taking the last 50 day sum of closing prices and dividing by 50. The average is re-calculated as new data comes in, creating a “moving average.”
The exponential moving average (EMA) provides more weight to the most recent prices in an attempt to better reflect new market data.
The difference between the two is noticeable when comparing long-term averages.
The 200-day EMA is quicker to react to the most recent price changes in indexes such as the S&P 500, which is not surprising since the exponential moving average has a smaller lag time, or more responsive, compared to the the simple moving average.
However, the SMA is a true indicator for the average prices over a specific time period. Consequently, most technical analysts would monitor the SMA in identifying support or resistance levels. [What a ‘Golden Cross’ Means for Stock ETFs]
Moving average preferences typically depends on an investors time horizons and objectives. We like to use the 200-day EMA to identify strong long-term trends and momentum in an investment. The 200-day EMA helps us determine when we are in or out of an investment. [How to Use ETFs in a Trend-Following Strategy]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.