One of the major shortcomings experienced while using a simple moving average is that it does not account for the ‘recentness’ of data points. Naturally, the significance for the most recent data points or share prices is more as it is incorporating current market sentiments, global scenarios, etc., unlike the one captured maybe a month ago. The exponential moving average (EMA) was introduced to overcome this inability of a simple moving average and provide investors better analysis using the most recent points.
Let us dive deep into what is an exponential moving average, its components, and its use in real-time markets.
This article covers:
Definition of EMA
EMA stands for exponential moving average. It runs along the same lines as the Simple Moving Average of measuring the direction of the trend over a period of time. However, EMA follows the price movements more closely and lays emphasis on the most recent data points. This is done by assigning them more weights, therefore making EMA sensitive to price changes.
Note that the exponential moving average is nonetheless a lag indicator, i.e, it doesn’t predict future price trends. It only estimates the continuation or reversal of the price trend based on the recent data points captured.
EMA can be of varied types depending upon the number of price points taken into consideration. 20, 50, 100, and 200 are some commonly used EMA.
For calculating EMA, SMA is needed as the base. So, for instance, if we want to calculate the 100-day EMA of any security, we first need to calculate its 100-day SMA. It’s the simple average of the previous 100-day’s data points.
The formula for calculating EMA:
EMA = (K x (C – P)) + P
C = Current price of the security
P = Previous periods EMA (we take SMA for the first-period calculation)
K = Exponential smoothing constant
The exponential smoothing constant here applies proportional weights to data points depending upon their newness. Naturally, the most recent data will be assigned higher weights.
Trading with EMA
Since it is susceptible to price movements, it can identify trends earlier than SMA. But, the very same also makes it very volatile.
When the market is trending, the EMA also follows the trend, i.e., in a bullish market, the EMA curve will also move upwards and vice-versa. As traders, one needs to look for signs where the curve is losing its strength or flattening because that can be used to mark entry and exit points.
Traders more often than not look to take positions in the direction of EMA, and for the same, the EMA curve becomes crucial. Traders are highly active when the price is near the EMA curve.
One needs to understand that EMA or even SMA may not help to capture the exact bottom and top of the market. The simple reason is that EMA is a lagging indicator, so there will always be a delay. Nevertheless, you can use EMA to trade in the direction of the trend.
EMA of different values can be used for different styles of trading. 10, 20, and 50-day exponential moving averages are usually preferred for short-term trends and subsequent trading. In comparison, 100 and 200-day exponential moving averages confirm long-term trends and are of greater significance while tapping reversals. Usually, when the price surpasses its 100 or 200-day moving average, it’s a signal of a trend reversal.
Applications of EMA
Strong support and resistance zones
Moving average curve acts as a strong support and resistance level, that is more often than not respected by the markets. In a bullish market, the EMA curve acts as a strong support level. On the contrary, during a bearish move EMA curve acts as a strong resistance level.
Confirms the market trend
EMA can be considered as the line of distinction between a falling and a rising market. When the price rises, the EMA curve rises too, and vice versa. Moreover, as long as the price is above the EMA curve, the uptrend is valid, provided there are no signs of trend weakness or reversal.
Used as the base for several technical indicators
Moving average convergence divergence (MACD), a popularly known technical indicator, uses the 12-day EMA and 26-day EMA to predict price trends. Traders extensively use EMA along with other technical tools and indicators like ADX and PPO. EMA has its own strategy too which is extensively used, known as the EMA crossover strategy.
EMA crossover strategy
Once data points/ prices are plotted on a chart, EMA lines are generated (for the desired number of days) that track the price movement. One could directly use the EMA indicator option available on major trading platforms to quickly have the EMA lines or even an excel sheet.
The most commonly used are 50-day and 200-day EMA. The interaction of these two EMA lines is studied to identify trade exit and entry points as well as strategies. The intersection and divergence of the lines (50-day EMA and 200-day EMA) are the major points of focus, that helps in predicting the price momentum.
- If the 50-day EMA line crosses the 200-day EMA line from below, the point of intersection is called the golden cross. This indicates a bullish run where the stock prices are expected to increase. It is considered a good strategy to enter a stock at this point.
- If the 50-day EMA line crosses the 200-day EMA line from above, the point of intersection is called a death cross. This indicates a bearish run ahead, wherein the stock prices are expected to fall. One can short or exit a trade at this point.
Many traders use simple moving averages to predict price trends. However, the exponential moving average covers the gaps in the concept of SMA and is helpful to make more relevant predictions. Instead of using just the average of prices, exponential average assigns weightage to each day-end price, laying emphasis on the most recent data. However, EMA should be used with caution and along with other indicators for accurate predictions.
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