What is an Exponential Moving Average?
A moving average (MA) is an indicator used in the technical analysis of the stock market. It monitors the average price movement of stock prices over time – calculated from the total of the closing prices of a given period. Moving averages help determine market trends, spot resistance, and support levels.
There are three types of moving averages:
- Exponential moving average (EMA)
- Simple moving average (SMA)
- Weighted moving average (WMA)
What is EMA?
An exponential moving average, also known as an exponentially weighted moving average places higher weightage on the most recent data points. Unlike a Simple moving average, an exponential moving average responds significantly to the most recent behavior of traders.
The 12-day and 26-day EMA are the most popular short-term averages. However, the 50-day, 100-day, and 200-day EMAs are commonly used to gauge long-term trends. The essential message here is that the exponential moving average can respond faster to changes in the price of an asset.
What is EMA in stocks and how does it work?
EMAs are essentially used for analysis and as a trading indicator in the stock market. Slopes in the EMA charts signal the uptrend or downtrend of a stock. The best way to assess a possible stock price turnaround is by comparing the exponential moving average (EMA) and the simple moving average (SMA) on a price chart. The point at which the long-term SMA and short-term EMA intersect is when the recent price trend is reversing.
The 50-day, 100-day, and 200-day EMA charts provide the resistance and support levels of stock. The resistance level is the point when the stock price begins to rise, whereas the support level is the point when the stock price begins to fall. When the price breaks the trend line, is the most optimal time to enter a trade.
By breaking down each part;
Interpreting EMA essentially entails the same rules that apply to SMA. Take into consideration that the EMA is significantly more sensitive to price movements. This can be both, good and bad. On one side of the coin, an EMA can help you in identifying trends earlier compared an SMA would. On the flip side, it will possibly experience more short-term variations than its corresponding SMA.
Utilizing the exponential moving average (EMA) to determine trend direction, one can steer their trade towards that direction. One should consider buying a stock when the EMA rises and the price drops just below the EMA or is near it. Inversely, sell a stock when the EMA falls, and the prices rally near the EMA.
As mentioned previously, moving averages also indicate support and resistance areas. A rising EMA leans towards supporting the price action, whereas a falling EMA leans towards providing resistance to price action. This bolsters the trading strategy of buying stock when the price is near the rising EMA and selling stock when the price is near the falling EMA.
Moving averages, including EMA, are not modeled to identify trades at the exact bottom and top. They may be helpful in the general direction of a trade trend, but with a delay at entry and exit points. However, the EMA has a shorter delay than the SMA in the same period.
How to calculate EMA?
Calculating EMA requires one more parameter than is usually required for the SMA. Suppose you want to use a 20-day EMA, then you have to wait till the 20th day to obtain the SMA. Consequently, on the 21st day, you can then use the SMA from the previous day as the first EMA.
SMA calculations are rather straightforward – the sum of the stock closing prices during a certain period, divided by the number of observations for that period. Explained simply, a 20-day SMA is the sum of the closing prices for the past 20 trading days, divided by 20.
In the next step, calculate the multiplier for smoothing (weighting) the EMA:
[2 ÷ (number of observations + 1)]
For a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952.
Going forward, use the following formula to calculate the current EMA:
EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)
The EMA gives higher weightage to recent prices, while the SMA designates equal weight to all values. The weightage given to the most recent price is greater for a shorter-period EMA as opposed to a longer-period EMA. There also exist variations of the exponential moving average, computed by using the open, high, low, or median price instead of using the closing price.
Using the exponential moving average in your trading strategy is not limited to any one instrument. You can set up an EMA line for a variety of trading instruments. However, you should remember to modify the EMA setup when you trade new instruments. as there is no one-size-fits-all.
Frequently Asked Questions Expand All
The 8-day and 20-day EMA tend to be the most popular time horizons for day traders. While the 50-day and 200-day EMA are better suited for long term investors.
When discussing EMA numbers (eg: 20 EMA or 10 EMA), this number symbolises the preceding period selected. This amount is in days, so 20 EMA means that the EMA is an average of the preceding 20 days, a 50 EMA is the preceding 50, and so on.