QUICK TAKES:
- The exponential moving average (EMA) and the simple moving average (SMA) are common indicators that measure the average closing price of a security over a set time period.
- Traders and investors monitor these indicators for signs of price support or resistance, and changes in trend.
- When short-term moving averages cross above long-term moving averages, that’s a bullish chart pattern called a golden cross.
- When short-term moving averages cross below long-term moving averages, that’s a bearish chart pattern called a death cross.
What is the Exponential Moving Average? What is the Simple Moving Average?
Exponential moving average (EMA) and simple moving average (SMA) are two common technical indicators that hold a lot of data about where assets have been and where they might be going.
EMA and SMA track the average closing price of a security over a set period of days. This is similar to the VWAP, or volume weighted price average, which tracks the average price that shares of a stock have traded at over the course of a single day.
Whether you’re looking at VWAP, EMA, or SMA, you can use these indicators to determine the average trade price of a security over a preset period of time.
Popular time horizons for exponential and simple moving averages are 50 days, 100 days, and 200 days. It’s worth noting that moving averages are lagging indicators. The larger the time period, the stronger the “lag”. That’s why many traders working on a shorter-term basis prefer using 10 and 20 day moving averages, which respond quicker to changes in market sentiment.
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EMA vs SMA: Calculations
Calculating the simple moving average is, well, simple. The SMA is the mean average of all closing prices within the given amount of days. To calculate the SMA, add all of the daily closing prices within the preset time period, and divide the sum by the total number of days.
Exponential moving average is a bit harder to calculate on paper. The key difference between the exponential moving average and the simple moving average is that the EMA assigns more weight to near-term price movement — meaning the EMA has less “lag” than the SMA.
How to Trade the Moving Averages
During healthy technical trends (trends that move in an orderly fashion, in a single direction), assets often lean on important moving averages as areas of support and resistance. For example, during a bullish period between November 2020 and September 2021, SPY (the SPDR S&P 500 ETF) generally “respected” its 50-day moving average — never remaining below the 50 DMA for more than a single day. Each return to the moving average provided SPY with a buyable bounce…
That is, until the trend started to break down. In October, SPY spent several days below the 50 DMA, representing weakening strength in the long-running bull market. Though SPY managed to retake the moving average for a brief period, by January of 2022 it broke below the 50 DMA once more, which would signal a multi-month top for the ETF.
Recently, the SPY ETF broke back above the 50 DMA. Investors and traders will be watching closely to see if this is a false breakout, like the one in late March, or a sign that market sentiment is shifting back to bullish. They’ll want to see the SPY ETF “respect” the 50 DMA as support.
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Investors will also be looking at how the various different moving averages interact with one another. If they see the 50 day moving average cross above the 200 day moving average, that would be another bullish sign: The “death” of the death cross, and the birth of a golden cross.
What is a Golden Cross? What is a Death Cross?
The golden cross and the death cross are both well-known technical patterns that are intended to predict a change in trend.
The golden cross occurs when a short-term moving average (frequently the 50-day moving average is used) crosses above a long-term moving average (frequently the 200-day moving average is used). The golden cross technical pattern is intended to confirm a bullish trend.
On the other hand, the death cross is the opposite: a bearish pattern that occurs when a short-term moving average crosses below a long-term moving average. Examples of both are shown below in Teladoc Health (TDOC) using the 50 DMA (blue) and the 200 DMA (orange).
Between the point where the golden cross begins and the death cross takes over, shares of Teladoc rise 153% (and much more if measured from peak to trough).
Conversely, once the death cross is confirmed, Teladoc falls more than 80% in just over a year.
As with any technical pattern, these aren’t fool proof. But there are plenty of investors with plenty of cash who pay close attention to these indicators. Sometimes their trades and investments can turn technical patterns like this into a self-fulfilling prophecy, making these patterns worth understanding — whether you’re a believer in technical analysis or not.
