Exponential Moving Average or EMA – Concept, Working, Calculation, Usage & more
Last Updated Date: Nov 17, 2022One of the oldest forms of technical analysis is the Exponential Moving Average or EMA. Additionally, it is quite a popular indicator that the majority of the traders choose to use.
Under this guide, you can learn a lot about exponential moving average. Mainly in trading practices, traders decide to use the exponential moving average.
The indicator most likely shows the changes in the price of a stock over a period of time.
About Exponential Moving Average or EMA Indicator
Ideally, the Exponential Moving Average is a technical chart indicator that records the price of a security over a specific duration. It falls under the category of a weighted moving average.
The indicator mostly gives more importance to the current price of data. As the simple moving average, the Exponential Moving Average can also help see the price trends over time.
Well, we can say that you can keep a watch over several EMAs at the same time by using moving average ribbons.
In simple terms, Exponential Moving Average is a type of moving average that gives more priority and importance to the most recent elements.
The indicator is also known as an exponentially weighted moving average.
An exponentially weighted moving average tends to react more quickly to recent changes in price as compared to the simple moving average. It is applicable to all observations in the duration.
The only difference is that Exponential Moving Average places more weight on recent prices while simple moving average doesn’t do so.
The agenda of all the moving averages is to create the direction in which the price of the stock is moving. It is based on previous price records. Thus, exponential moving averages are lag indicators.
They have this name because they don’t consider the future prices at all; all they do is highlight the trend that the stock price follows.
Thanks to its unique calculation, the Exponential Moving Average follows prices as compared to the corresponding SMA.
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How does EMA Indicator works?
When it comes to interpreting the Exponential Moving Average, you can apply the same rules as the Simple moving average.
It proves to be a double edge sword. It can help you in identifying trends earlier than SMA.
The drawback here is the Exponential Moving Average is most likely to experience more short term changes as compared to SMA.
If you want to determine the direction of the trend, then you can surely use the Exponential Moving Average.
You can consider buying when the EMA increases and the prices also drip near. At the same time, you can consider selling when the EMA decreases as the prices even near falling.
Moving averages like Exponential Moving Average are not specially designed to identify the very top and bottom of the trade.
No doubt, moving averages can help you in trade, but there might be some delay at both entry and exit points.
As compared to simple moving averages, the Exponential Moving Average has shorter delays.
How to calculate Exponential Moving Average?
By now, you must know that the Exponential Moving Average uses the formula of the previous indicator in its calculation.
In simple terms, we mean to say that the Exponential Moving Average includes everything in its current value.
The most recent data on price has a significant impact on the moving average. On the other hand, previous prices have a minimum impact.
Formula for calculating Exponential Moving Average
EMAToday=(ValueToday∗(1+DaysSmoothing))+EMAYesterday∗(1−(1+DaysSmoothing)).
No doubt there are a plethora of choices available for soothing, but two is one of the most common options.
It gives more weight to more recent observations. Additionally, if the soothing factor enhances, the current observations have more influence on the EMA.
When it comes to calculating Exponential Moving Average, it requires one more observation as compared to the simple moving average.
For example, if you plan to use 20 as the number of days for observation under an indicator. Then you need to wait for 20 days to get the simple moving average.
You can use the SMA from the previous day as the first EMA for the previous day on the 21st day.
It is relatively easy to calculate the simple moving average as all you need to do is sum the stock prices during a specific time period.
Lastly, divide the observations for a particular period. Using the above example of 20 days, SMA is the sum of 20 days divided by 20.
You can calculate the multiplier for smoothing the EMA in the next step. The formula goes like [2 ÷ (number of observations + 1)].
The simple moving averages give equal weightage to all values, while EMA gives priority to recent prices.
How does Exponential Moving Average or EMA helps in Trading?
One of the most commonly quoted short term averages are 12- and 26-day exponential moving averages.
You can use these to create indicators, including moving average convergence divergence, the percentage price oscillator.
For long term trends, you can use 50- and 200-day EMAs. A technical signal that shows an occurrence of reversal is when the price of the stock crosses its 200-day moving average.
Traders find moving averages quite useful as they use technical analysis. But these signals create havoc if you use them incorrectly.
Drawbacks of EMA Indicator
Well, it is not yet clear if recent days need to be weighed more or not. But the majority of the traders believe that the current trend of a security reflects well with the new data.
The drawback here is that the indicator highly relies on historical data. Almost all economists believe that markets are pretty efficient, and the current price features all the information.
Exponential Moving Average or EMA Indicator – Conclusion
Well, we can say that Exponential Moving Averages are quite popular as they offer more weight to the recent prices.
Above all, they lag less as compared to other indicators. Hence you can rely on this indicator.
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