Today, we answer two excellent questions from readers.

Could you explain when it's appropriate to use the "simple moving average" as opposed to the "exponential moving average"?  Is it important to make a distinction between the SMA and the EMA or can they be used interchangeably?    Thanks!  I enjoy your educational columns.

Answer: It's actually a pretty important question. We use both simple moving averages (where all the bars or prices used in calculating the average are weighted equally) as well as exponential moving averages (where the most recent prices or bars are overweighted when calculating the average). As you may guess, the exponential moving average, or EMA, is quick to respond, while the simple moving average, or SMA, is relatively steady. So to answer the question, yes, it's important to make a distinction, and no, they really shouldn't be used interchangeably. Otherwise, you might miss the best feature(s) of one type or the other.

To figure out which style you want to apply in your case, think about your particular method of trading. Do you want to respond quickly to recent changes in an effort to catch a piece of new momentum? If so, an EMA will give you a lot of responsiveness. The downside is, you have a very volatile moving average line that could lead you to a lot of fakeouts. On the other hand, if you apply an SMA to swing trade signals (lasting only a few days), by the time you got a signal from your moving average line, the "swing" may be over. You have a low-volatility line, but it's slow to generate meaningful crossovers....or whatever your signal is. That's the trade-off - responsiveness versus stability. If you need to act fast, use an EMA. If you specifically don't want to react too quickly, use an SMA.

We like to apply EMAs to our short-term charts and trades, and SMAs to our longer-term (multi-week) charts and trades. There's no rule of thumb behind the reason we do so - just years of observation.

I am new in learning about technical analysis and get several newsletters on "what's happening" and "what it means." Most use "charts" of one type and period or another. To a layman, what is the difference in a 4 month time period vs 6 months?  3 years vs 2?  Why all the different time frames? and why not 4 years as this seems to be a cycle period? Thank-you.

Answer: Another very good question...one that exposes the oddities that a lot of traders have come to accept without question.

There is actually some rationale behind the most frequently used moving averages. I think a lot of it has to do with investor psychology, which of course is eventually reflected on stock charts. For instance, the 10 and 20 day moving averages have become the standard for short-term trading. Think about those timeframes in non-numerical terms though. That's half of one month (10 trading days = two weeks), and one full month (20 trading days = four weeks). Are traders aware of this when they're buying and selling and forcing charts higher and lower? Very doubtful, but subconsciously their choices and actions can reflect the timeframes in which they think.

Similarly, the 50 day and 200 day lines reflect a longer-term psychology. Fifty days is about two months (some months have five weeks), while 200 days is about nine trading months. Again, most traders don't think of it like that, but they do act in ways that reflect those timeframes. Interestingly, studies have shown that the a Fed action (regarding interest rates) or legislative action (regarding fiscal and tax policy) takes about nine months to really have the noticeable intended effect on the economy. Since the stock market is often (allegedly?) a function of the economy (although not synchronized), it makes sense that the charts tend to respond in nine-month (200 day) segments. That's why the 200 day line is the grandmother of all the other moving averages. 

Can you venture from the most common moving averages and apply your own? We always encourage experimentation. However, given that these moving averages have become 'common' through years and years of trial an error, I'd say it would be tough to find a new but meaningful timeframe or pattern. But then again, there's always something that somebody else hasn't discovered yet.

You also asked about using a four year moving average, since the economic cycle (on average) lasts four years. That's actually a reasonable idea, except for two things. First, stocks don't move in sync with the economy......sometimes they aren't even close. The time may be right 'economically', but that may not mean your stocks (or any stocks) move higher. And second, even if stocks and the economy were correlated, your moving averages would essentially "be" the market, without offering you any advantage. And being slow movers, by the time you got a signal, you'd either be several months late getting in or several months late getting out, depending on how you were using your averages. The best you could reasonably hope to do would be to match the market. If that's ok by you, then the easiest thing to do would be to just buy an index fund and leave it alone. Hopefully, though, you have the desire to outperform the market. If that's the case, your moving averages would at least have to have something of a predictive nature to them. That means you need them to get you in before the majority of the bullish moves, and get you out before the majority of the bearish moves. And to do that, you have to be willing to take action before the crowd does.

Price Headley is the founder and chief analyst of BigTrends.com.