EXPONENTIAL MOVING AVERAGE – TALKING POINTS:
- What is Exponential Moving Average (EMA)?
- How is the Exponential Moving Average (EMA) calculated?
- How do you use the EMA in your trading strategy?
- Exponential Moving Average: A Summary
- Become a better trader with our trading tips
WHAT IS EXPONENTIAL MOVING AVERAGE (EMA)?
The exponential moving average (EMA) is a derivative of the simple moving average (SMA) technical indicator. Compared to the SMA, the EMA weighs recent price changes more heavily than later changes in price. This means that the EMA is more responsive than the SMA to current price fluctuations.
The chart below represents the difference between the SMA and EMA. The 200-EMA is seen reacting earlier to the highlighted decline in price on the left side of the chart. The same is seen with an increase in price emphasizing the variance in lag.
HOW IS THE EXPONENTIAL MOVING AVERAGE (EMA) CALCULATED?
Nearly all charting packages perform this calculation on the respective platforms and apply the calculation to the chart. For the numbers people, the formula will be shared below, but the important thing to remember is that EMA will react quicker to price trends relative to SMA.
The exponential moving average (EMA) is a weighted moving average calculated by taking the average price for a particular market over a defined period of time and adjusting this figure to increase the weight of recent price data. The formula below breaks down the components of the calculation making it easy to visualize and compute.
HOW DO YOU USE THE EXPONENTIAL MOVING AVERAGE IN YOUR TRADING STRATEGY?
The EMA trading strategy can be used in the same manner as the SMA. When the shorter-term EMA crosses above the longer-term EMA, this signals a buy signal. When the shorter-term EMA crosses below the longer-term EMA, traders look to enter short positions. The EMA values are completely up to the trader’s preferences. The example below uses 20, 50, and 200 EMA designations, while other traders favor Fibonacci figures.
The chart above depicts a USD/CAD daily chart with the 20, 50, and 200 EMA indicators added. The 200 EMA is used to identify the overall long-term trend. In this case, the price is above the 200 EMA from 2014 to mid-2017 (upward trend), after which the price crosses through representing no clear trend. Thereafter price resumes its trajectory above the 200 EMA confirming the upward trend. Once the trend is confirmed, traders utilize the shorter-term EMA’s to identify possible entry points. Highlighted above shows a probable entry point indicating a ‘buy’ signal. The circle represents a ‘buy’ opportunity with the 20 EMA crossing above the 50 EMA line.
EXPONENTIAL MOVING AVERAGE: A SUMMARY
The EMA is a valuable indicator to have as a trader. This indicator is simple to use and a great way for novice traders to get a feel for technical analysis in relation to identifying trends and entry prospects. More experienced traders tend to use the EMA in conjunction with other tools, but this makes it no less influential.
Steps to follow when trading with the EMA:
- Use long-term EMA to identify the general trend
- Identify crossing points between shorter-term EMA’s and longer-term EMA’s
- Look to enter ‘long’ or ‘short’ positions accordingly