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Just like any other technical indicator, the EMA exists to give traders an edge over others like them in the market. In the ever-volatile and dynamic world of stock market trading, there’s no such thing called too much information – and the EMA is a testament to that sentiment.
The EMA is not a static indicator – which means it’s not one that analyses data on a case-to-case basis. It is a continuous indicator, which means that it’s constantly working to analyse the change in an asset’s price. It never stops doing what it does – which is calculating an evolution of moving averages.
In this article, we’re going to explore what the EMA is, what its underlying principles are, the rationale behind its importance, and its role in the toolkit of numerous traders around the world.
What is the EMA?
EMA is short for Exponential Moving Average. The EMA is one of several other moving averages, which are used to check the average price movement of a security over time. Moving averages use the closing prices of the asset over specific periods to perform these calculations.
Moving averages like the EMA can be used to determine broader market trends. The larger the time frame they consider, the broader is their analysis over time. Generally, there are three main types of moving averages:
- Simple moving average (SMA)
- Exponential moving average (EMA)
- Weighted moving average (WMA)
The EMA gives more weightage to more recent data points – which means that recent price movements have a greater effect on the EMA than on other averages. When compared to an SMA (which applies an equal weight to all observations), the EMA tends to adjust course a lot with recent volatility.
Note: The EMA and the SMA are both indicators that chart historical price movements. They do not predict future movements per se. Traders use the patterns they make over time to understand how a particular stock’s price regularly moves and make calculated bets based on that information.
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Calculating the EMA manually
Although every decent charting and trading software has an option for EMA now, here’s a step-by-step on how to calculate the EMA manually. This will help you understand the mechanics behind the indicator:
- Choose a time frame: The first step in calculating the EMA is to determine the time period for which you want to calculate the average. Typically represented by n”, this frame can be customised based on your strategy. For instance, you might use a 10-day EMA for short-term trading or a 50-day EMA for longer-term investing.
- Start with the SMA: To begin calculating the EMA, you first calculate the SMA for the specified time period. The SMA is the arithmetic mean of the closing prices over that period. You sum up the closing prices for the specified number of days (chosen in Step 1) and divide by the number of days.
Hence, the SMA = Sum of Closing Prices / Number of Days
- Calculating the EMA: Like we noted before, the EMA differs from the SMA in that the EMA gives more weightage to recent prices. The weighted multiplier for the EMA, hence, is calculated as follows:
Weighted Multiplier = 2 / (n + 1)
Following this, formulas for the EMA can be applied:
EMA = (Closing Price – Previous EMA) * Weighted Multiplier + Previous EMA
- The “Closing Price” is the most recent price of the asset.
- The “Previous EMA” is the EMA calculated for the previous day (or the initial SMA on the first day of calculation).
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The difference between EMA and SMA
Although the EMA and SMA are both moving averages used to calculate price action over time, there are some nuances to note for trading.
- The SMA is about calculating the average price data for a particular trading period. The EMA, on the other hand, focuses more on the current data.
- While a decent SMA can be derived in a relatively short-time period, it takes much more than 10 days worth of data to get an accurate 10-day EMA.
Using the EMA in stock trading
There are some things you need to note before using the EMA in stock trading.
- The EMA is more sensitive to recent price movements compared to the SMA. Hence, current volatility in asset prices tend to impact the EMA’s trends more than the SMA’s.
- Short-term sensitivity means that the EMA can be used to predict short-term patterns and movements more reliably.
- The EMA determines the trend direction. Generally, when the EMA rises, it’s a bullish signal and vice versa.
- The EMA could, in certain circumstances, be used like a support for a rising price action.
Usually, the EMA is used for a 10, 20, 100, or a 200-day average. The 12 and 25-day averages are used to calculate both the Moving Average Convergence Divergence (MACD) and PPO – Percentage Price Oscillator (PPO).
Experts, however, say that the EMA should be used carefully when trading. While EMA signals are oftentimes reliable and helpful, they can frequently be wrongly interpreted as well.
In principle, EMAs are lagging indicators – which either confirm or reject market movements. The EMA can often be reliably used to counteract the adverse effects of price lags since it’s more sensitive to recent price movements. For instance, it is a positive trading signal when the EMA indicates an upward trend in an already-bullish market.
Also Read: Speculation / Speculative Trading
Limitations of the EMA
Experts are still debating whether more emphasis should be placed on current price changes or not. Many traders believe that new data (or data that’s more current) gives a better reflection of the current trends of the security rather than historical data. Others disagree. They believe that giving more weightage to current data leads to more false alarms.
In the end, the EMA – along with the SMA – is a very good indicator of the current price movement. The EMA, by taking into account current events more impactfully, gives traders a better understanding of short-term volatility in the market. However, just like any other technical indicator, the EMA should be used in conjunction with other signals and metrics to make a more accurate and informed decision.
Frequently Asked Questions
There’s no “one size fits all” answer to this question, as the best EMA for your stock depends on several factors:
Trading style: Shorter-term traders prefer shorter EMAs like the 12-day or 20-day for quicker reactions to price changes. Longer-term investors could also use 50-day or 200-day EMAs.
Stock behaviour – EMAs also depend on historical price action.
Market volatility – In volatile markets, shorter EMAs might be too sensitive and generate excessive signals.
EMAs generally tells traders two things:
Trend direction – The slope of the EMA indicates the current trend. An upward slope suggests a bullish trend, while a downward slope signals a bearish trend.
Trend strength – The steeper the EMA slope, the stronger the underlying trend. A flat EMA can indicate indecision or consolidation.
The EMA is calculated by assigning weights to each closing price, with the most recent one receiving the highest weight, and the older prices gradually decreasing in weight. This formula makes EMA react more quickly to recent price changes than a regular SMA. Usually, charting software will have an embedded EMA function ready for you to use.
Crossovers – When a shorter EMA crosses above a longer EMA, it can signal a potential bullish reversal. On the other hand, a crossover in the opposite direction might indicate a bearish one.
Divergence – When the EMA diverges from the price action, it can be a warning sign for a trend reversal again.
Support and resistance levels – EMAs themselves can act as dynamic support and resistance levels. A price that’s bouncing off an EMA might indicate a price change.
This is the strategy that the 10 EMA follows:
– Buy when the price is above the 10-EMA.
– Sell when the price closes below the 10-EMA.
This strategy aims to capture short-term trends and can be effective in volatile markets. However, it can also generate frequent whipsaws (false signals) in similar markets.