Moving averages are essential parts of the trading industry. If you have read or even watched trading-related media, you must have heard about these averages.
In this report, we will look at exponential moving average and how you should use it in the market.
What is Exponential Moving Average (EMA)?
To better understand what EMA is, we need to look at its foundation. The EMA is a derivative of basic or simple moving average (SMA).
The SMA is calculated by taking the close, open, high, or low price of an asset within a certain period, adding them, and dividing it with the period.
For example, if the price of a stock in three days is $25, 30, and $28, the SMA is $27.
On the other, the exponential moving average tends to reduce the lag provided by the SMA. It does this by adding more weight to the recent prices of an asset.
In this, the EMA of an asset today depends on the EMA calculation of all the previous days.
The chart below shows the 50-day EMA (red) and the 50-day SMA of Apple.
Exponential moving average calculation
The process of calculating the EMA is usually relatively different with that of the SMA. There are three key steps in calculating this average:
- You need to calculate the SMA of period you are focusing on. In this, you just add the values and then divide by the periods.
- You need to calculate the weighting multiplier. You do this by using the following formula: [Multiplier = (2 / (Time Periods + 1))]
- After that, you calculate the EMA for each day using the closing price, the multiplier, and the previous day value.
The third step is calculated as shown below:
|EMA = (Close – EMA (previous day)) x multiplier + EMA (previous day)|
Do not worry if this seems complicated. As we have said before, you don’t need to know how to calculate the EMA. Indeed, most people in Wall Street don’t know how to do the calculation.
Instead, you just need to know how to apply it on the chart and interpret it.
How to use the EMA
There are several ways of using the exponential moving averages. The one We prefer is to use the indicator to find reversals. A good way to do this is to use a fast and a slow EMA.
A fast EMA is a shorter-period one while a slow one is a longer-dated one.
The idea is to note where the two indicators have a crossover. When this happens, it is usually a signal that the price will start to reverse.
A good example is shown on the EUR/USD pair below. As you can see, the price tends to reverse when the 14-day and 28-day exponential moving averages cross over.
Advantages of using the exponential moving average
There are several benefits of using the EMA. First, it is among the simplest indicators you can use in the market as shown above.
Second, the EMA tends to be relatively accurate, especially when you are identifying reversals.
Third, the EMA can be used easily with other indicators like MACD and momentum.
Finally, if you are a statistician, it is relatively easy to calculate the indicator.
If you are serious about trading, then moving average is a must indicator to know.
A good way to start is to come up with a strategy using paper trading. As you can see above, We tend to use the 14-day and 28-day EMAs.
You can experiment with other numbers as you craft the strategy.