The Exponential Moving Average is a technical indicator that is designed to minimise "market noise" and enable the true price trend and market sentiment to be clearly identified. It differs from other moving averages, as it places more emphasis on the most recent time periods.
The difference in the way the EMA averages it's data, by applying more weight to the most recent data points, means that the Exponential Moving Average reacts more quickly than other averaging indicators by minimising the lag between actual price action and its reporting.
In This Article:
- What Is The Exponential Moving Average
- Why Do Traders Prefer The EMA
- What Does The Exponential Moving Average Tell Us
- How To Use The EMA Indicator
- Summary
What Is The Exponential Moving Average
The Exponential Moving Average (EMA) is a moving average indicator that calculates the average of closing prices over a set number of periods. It is designed to smooth out short term price fluctuations or "market noise" so that the real trend and market sentiment can be easily traced. Where it is different from the Simple Moving Average (SMA) is that the average is adjusted to give more weight to the most recent prices, as they are a better indication of current market sentiment. The advantage of the weighted average is that the EMA reacts quicker to changes in market sentiment, we demonstrate this on the technical chart below:
On the above GBG/CHF 30m technical chart there are three changes in market sentiment. The first being a downward trend, followed by an uptrend, and finally a second larger downtrend. On each of these three occasions the Exponential Moving Average (blue line) reacted quicker than the SMA (red line), due to adjusted weighting of current sentiment.
Why Do Traders Prefer The EMA
Moving average indicators are trend indicators, highlighting market sentiment of a pre-defined number of periods. Traders prefer the Exponential Moving Average as it identifies changes in market sentiment earlier than other indicators. This is beneficial to traders for two reasons.
Early Entry Into A Trend
Referring back to the technical chart above, it is clear that the EMA identified the change in market sentiment earlier than the SMA. This allows traders to enter a trading position early into an emerging trend. If the SMA was relied upon, a trader would enter a trade later into the emergence of a trend, missing out on early gains.
Exiting A Position
Taking a position on a trend can prove very worthwhile, particularly if entry was early and the trend had momentum over a long period. A problem for every trader is calculating when the trend will end! The Exponential Moving Average provides critical information on changes in market sentiment. As the indicator gives more weight to current data, it will quickly reflect any changes in momentum. This can be interpreted as a trading signal to exit the position before prices reverse.
What Does The Exponential Moving Average Tell Us
The EMA is a trend signalling indicator and provides information on whether sentiment remains in line with the current trend or whether is changing. It is important that the indicator is configured in a way that compliments a trader's strategy.
If a trading strategy is focused on short term trading, entering and exiting positions quickly, the Exponential Moving Average needs to be configured to identify trends on the short term. To make sure the EMA is effective for a short-term trading strategy, it should be configured to calculate the average over short time frames ranging from 12-26.
Longer time frames should be set for averaging if trades are to be based around longer time frame. Average 50–200-time frames are sensible for longer term trading.
How To Use The EMA
There are two main methods of trading using the EMA:
Support & Resistance - the EMA indicator can be used as a dynamic level of support and resistance. If price action is trading above the EMA indicator, the market is trading upwards with a bullish sentiment. Within this environment, traders may wait for the price to fall towards support before placing a long trade, in anticipation of price to pivot.
Alternatively, price action may be below the EMA trading downwards in a bearish market. in which case traders will wait for price to move towards resistance before entering a short position.
If using the EMA to trade as support and resistance, it is important to remember that the EMA does not always pivot when in contact with support or resistance and will sometimes break through. For this reason, always protect a position with a stop loss order placed just above or below the EMA.
Multiple Indicators - A popular method of using the Exponential Moving Average (EMA) is to use multiple indicators, each with different time periods. The parameters of the EMA that are set are entirely the decision of the individual, but a short-term EMA (50 periods) and a longer-term EMA (100 periods) would be a suggestion. The advantage this provides to a trader is that the long-term trend is identified, and the shorter-term trend can be used to identify possible entry points.
When using multiple EMA indicators there are two signals to look out for. When the short-term EMA crosses the long-term EMA moving upwards, this is called the "Golden Cross" and is a strong indicator of a bullish trend, conversely, when the short-term EMA crosses the longer term downwards, this is called a "Death Cross" and is a bearish signal.
Summary
The Exponential Moving Average (EMA) is a useful technical tool in identifying trends, entry positions and market sentiment. It differs from other moving averages as it is adjusted to give more weight to current price action, it reacts quicker and allows traders to find entry positions earlier. The EMA can be interpreted as a moving support and resistance, providing easy to interpret entry points. Using multiple EMA indicators and tracing short term behaviour to long term trends, help to identify bullish and bearish opportunities.
