Hello! Today I want to answer these questions: which is the most useful type of moving average? and is the exponentially weighted moving average the best one?
I’ve already discussed about the six main usages on moving averages. Today however, I want to discuss with you about a specific peculiarity of these indicators: the weighting method.
So, let’s start!
Why the method of weighting used is critical for moving averages
There are a number of different ways to average data while constructing these kinds of indicators. The exponentially weighted is just a type of moving average, even if it’s the most famous one.
But WHY the weighting method is so important?
Because the method used determine the sensitivity of moving averages toward the latest prices.
Look at the following example about Ethereum and Bitcoin. I’ve plotted a simple moving average (SMA) and an exponentially weighted moving average (EMA), both referring to 9 periods of look-back:
You can notice that the pink line is quicker than the blue one. That’s because an exponentially weighted moving average reacts faster to price changes than a simple one.
This happen because a simple moving averages assign an equal-weight to all prices considered in its construction, while an exponential ones assign a higher weight (and so importance) to latests data.
Remember: moving averages are lagging indicators based on past price action! So, it’s important to find the best method of weighting able to reduce their lag.
Exponentially weighted moving average: there’s much more than this!
The exponentially weighted moving average isn’t the only way we have for increase the reliability of these indicators and so their everyday usage.
Let’s now review each type of moving averages. Anyway, I think you will find interesting hints for your own trading in the paragraphs below.
Simple Moving Average (SMA)
A simple moving average is one of the most common averages used by traders all over the world.
As for any other type of moving average, it’s a rolling average (that’s why is called “moving”) in which every time a new price is registered, the oldest one is dropped from the computation.
It’s named “simple” since each price assume an equal weight while constructing this indicator.
Look at this example referring to the German stock index DAX 30:
Exponential Moving Average (EMA)
An exponentially weighted is a front-weighted moving average. By far is the most used average by market participants.
They are calculated multiplying past prices for and exponential weighting ratio, which increase as we get closer to recent past prices.
Its particular weighting method favours recent price action: that’s why these rolling averages are more sensitive to market action and provides early signals compared to their simple correspondents.
Considering the same example on DAX 30:
Triangular Moving Average (TMA)
A triangular moving average is a double smoothed moving average.
What does it means?
Simply, it is a moving average constructed from a previous moving average (usually and EMA).
Even if a triangular moving average is able to provide a smoother indication of price action, I’m not a huge fan of this indicator. Double smoothing means double lagging, that’s why I don’t want to use it in my everyday trading.
Weighted Moving Average (WMA)
Weighted moving averages are quite similar to the exponential ones. They are front-weighted, in which latest prices have more impact than elder ones.
Main difference is that the weighting factor of the rolling average is no more exponential (as for a classic EMA), but linear.
Look at the differences existing between EMA and WMA:
Volume Weighted Moving Average (VWMA)
A volume weighted moving average adjust the rolling average of past price considering market volume.
The logic behind this indicator is quite simple: the greater is the volume registered in a particular trading session, the more the influence on the moving average.
In the chart below about DAX 30 index, you can see the difference between the EMA and VWMA both on 20 periods:
Adaptive Moving Averages: How to Account for Market Volatility
Usually, an adaptive moving average is exponentially weighted: in this case however, the weighting factor is modified to account for market volatility.
There are different types of adaptive averages, but the 2 most important are these:
- KAMA – Kaufman‘s Adaptive Moving Average
- FAMA – Following Adaptive Moving Average
Look at the following example:
We can see an EMA and a KAMA, both of 20 periods.
Looking at the KAMA, we can notice that when volatility increase, this tends to moves away from price action; rather, in a condition of lower volatility, the KAMA becomes flatter, providing zones of support and resistance in the market.
Moving Average Smoothing: an additional way to filter price action
Till now, we have seen that there is much more than the only exponentially weighted moving average.
But that’s not all.
We can modify each of the six types of moving averages we’ve seen right now in order to increase the filtering action of these indicators.
Simply, we can calculate a moving average from a previous moving average: that’s why we talk about a double smoothed moving average or even in some cases to triple smoothed moving average.
Pros and Cons about Moving Average Smoothing
In my article about the six main usages of moving averages, I talked about the possibility to use moving averages for filter the erratic movements of price action.
By double or triple smoothing a moving average we can improve this filtering action.
Nevertheless, we cannot enjoy this improvement without giving up something else: the more the degree of smoothing, the higher is the lag of this indicator.
So, in light of what we’ve seen till now, can we say that the exponentially weighted moving average is the best one? In my opinion the answer is subjective.
If we want to provide an overall answer, I can say that yes, the exponential moving average is the best one.
But in the real world, I think It depends on your goals, your trading style and your strategies. Are you interest in account for market volatility? Well, maybe you can opt for a KAMA or FAMA. Or rather, you want to consider volume in your trading strategies? Well, maybe a VWMA is a better choice for you.
I hope I provide you with an answer to this question, moving averages are so widely employed that is necessary their knowledge if you want to be a profitable trader.