Although the simple moving average is a great tool, there is one major flaw associated with it. Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows:
Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.
When trading, it is far more important to see what traders are doing now rather than what they did last week or last month.
