Understanding Simple and Exponential Moving Averages
Tue, 09/11/2012 - 11:58am
In our last blog tip we talked about the general concept of risk management and why it's important for profitable trading. This week we want to dive a little deeper into some specifics that new traders might have questions about!
As new traders, lots of us freeze up when we hear terms like simple moving averages and exponential moving averages. But there's no need to stress! We want to go over these tools and help you better understand how they can benefit your trading!
To find a 20-period moving average (these can be any periods—1-minute, 5-minute, etc), we add up the closing values for all 20 periods. You take the sum of those numbers and divide it by 20 (the number of periods). This gives us our average, but not our moving average. To get a moving average, we plug in new periods as they occur, and for every period we add, we remove the oldest period. This perpetual addition of new periods and removal of old periods is the movement we refer to when we say moving average.
There are two types of moving averages: simple and exponential. They both work as described above, but the difference lies in how important they consider certain periods to be. In a simple moving average, every period is weighted equally. Because it might be argued that older periods have less relevance to the future, an exponential moving average weighs the recent periods more heavily than those further back.
To get a better picture of what each of these averages can tell us, let's think about moving into a new home near a fault line. One seismologist, representing the simple moving average may tell you, “Based on the data, we know there hasn't been an earthquake in 100 years.” This gives you a reasonable picture of a place where earthquakes happen every periodically, but it's nothing to worry about. Another seismologist, representing the exponential moving average, might say, “Based on the data, we know there hasn't been an earthquake in 100 years, and we're overdue by 50 years.” This is quite a bit more relevant to you, as it helps you understand that as every year goes by, an earthquake is that much more likely to happen.
That being said, it's worth noting that prices tend to react off of simple moving average much more often. Of course, you should find which tools work best for you, and always use them in conjunction with others to confirm any movements that you're looking for.
We hope this has helped you better understand moving averages. Are there any other topics you'd like to see covered on the blog? Feel free to email us any ideas, and check out our Orientation Webinar if you'd like to learn more about the Apiary Fund.
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