In order to reduce the lag in simple moving averages, technicians often use exponential moving averages (also called exponentially weighted moving averages). Exponetial moving averages reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the exponential moving averages time period, the more weight given  that will be applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while the 20-period exponential moving avarage weighs the most recent price 9.52%. Calculating and EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average.

 

Which moving average you use will depend on your trading and investing style and preferences. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer to use exponential moving averages for shorter time periods to capture changes quicker. Some investors prefer simple moving averages over long time periods to identify long-term trend changes.

 

The more sensitive an indicator is, the more signals that will be given. These signals may prove timely, but with increased sensitivity comes an increase in false signals. The less sensitive an indicator is, the fewer signals that will be given. However, less sensitivity leads to fewer and more reliable signals. Sometimes these signals can be late as well.

 

For moving averages, the same dilemma applies. Shorter moving averages will be more sensitive and generate more signals. The exponential moving avarage, which is generally more sensitive than the simple moving average, will also be likely to generate more signals. However, there will also be an increase in the number of false signals. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability.  You will need to know the market you are trading in order to use the best moving average.  They will be different for different markets like the forex and commodity futures.

 

• Trend identification/confirmation -
   

  There are three ways to identify the direction of the trend with moving averages: direction, location and crossovers. The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.

   

• Support and Resistance level identification/confirmation -  Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.

 

Moving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify securities that are suitable for analysis with moving averages and how this analysis should be applied.

 

The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages will help ensure that a trader is in line with the current trend. However, markets, stocks and securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.