Introduction of EMA
The popularity of the stock market cannot be understated. The notion of making thousands of dollars’ worth in profit just by making an opportune move has caught the eyes of many, and if that doesn’t turn any new heads, then those daily trading volumes might definitely do the trick.
In other words, there’s a ton of value to be had here; however, getting there is no easy task. The potential for loss is real, and if you’re a newcomer, then all those charts and figures may be quite overwhelming.
This is why so many indicators exist in the first place. The idea that one could make more sense out of the market and its future is appealing to any serious trader.
And in this sea of indicators, it’s hard to understate the impact that moving averages, or MAs, have had on the landscape.
Their role in filtering out that market noise has made traders a bit more certain of their positions than if they were left to their own devices.
This has resulted in the spawning of numerous variants of that base SMA, short for simple moving average, each catering to a specific requirement.
But the variant that we’ll be directing our attention towards is the EMA, i.e., the exponential moving average. So, without further ado, let’s get into it.
What is the EMA(Exponential Moving Average)?
Moving averages have become a common method for technical traders to start the procedure of price analyses.
It’s often among the first indicators that traders will integrate into their charts. On its own, it can serve as a decent measure, but its values can be compared to other indicators as well, and it is there that its true potential is actualized.
Now, moving on to EMAs. Firstly, any in-depth discussion mentioning them would be incomplete without examining SMAs, the most basic iteration of moving averages.
It’s calculated by totaling all the closing prices of a certain number of days and then dividing by those same days, so if it’s the prices for four days, then you’ll divide it by four.
The Purpose of EMA
The whole point of moving averages is to identify trends, smooth out that price data, and generate signals that traders may use to know when to buy and sell.
While SMAs and EMAs can both do that, the main difference between them is that the latter assigns more influence to recent figures and less to old data with the incorporation of a weighting variable within its calculation. This essentially allows them to be more responsive to price changes.
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How is the EMA Calculated?
So, when you’re calculating the EMA, there are usually three steps that you need to carry out, and these include calculating the SMA for the period, calculating that multiplier for weighting that EMA, and finally, calculating the existing EMA. We’ll get more into it below.
EMA Formula
The EMA has to start somewhere, and that has to do with the SMA itself. Suppose you wish to utilize 10 days as the time period for the EMA.
Then you have to wait until that 10th day to acquire the SMA. On the 11th day, you may then utilize the SMA from that previous day as the initial EMA for yesterday.
Then comes the multiplier, obviously, and the formula for that is:
multiplier = [2 / (Selected Time Period + 1)].
The final step would be to use the closing price, the multiplier or the weighting variable, and that initial EMA. It’s all computed through this formula:
Current EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier).
Key Parameters of EMA
The key parameters that you may have noticed here would have to be the weighting variable, aka the sensitivity for your EMA, and the time periods themselves.
So, you may increase your sensitivity by using 3 instead of 2 in that multiplier formula, for instance. The higher the sensitivity, the more responsive the EMA is to recent data.
How to Use EMA in Trading
So, now that you have a bit of an idea of what the EMA can be, it might be the right time to get into how you can use it in your trading endeavors.
Trend Following with EMA
Like any other moving average indicator, EMAs tend to be more suitable for trending markets.
So, if the market is within a sustained and strong uptrend, then that EMA indicator will also display an uptrend, and the same is true for downtrends and flat markets.
Knowing the current state of things, you can consistently follow trends and act accordingly with your positions.
EMA Crossovers
Utilizing EMA crossovers tends to be one of the most common trading strategies out there. Here, traders base their trades on the positions of a short-term EMA that relates to a longer one.
For instance, traders tend to be bullish when a 20 EMA crosses over a 50 EMA, and they only become bearish if that 20 EMA falls under the 50 EMA.
EMA and Price Action
Interestingly, the EMA indicator’s relation to the price can also be a signal of sorts. For instance, when the price goes beyond the moving average, you get an upward trend.
And if the price is below the MA, then you have a downtrend.
EMA Strategies for Different Trading Styles
In this section, we’ll briefly cover how the EMA relates to some of the primary trading styles observed within the industry, namely swing, day, and long-term trading.
Day Trading with EMA
For day trading, which focuses heavily on short-term profits, traders may incorporate shorter time frames within the EMA to reflect that, and make use of the scalping strategy.
Swing Trading with EMA
Swing traders, since they’re targeting medium-to-long-term gains, can incorporate time frames that are indicative of that, and since they have more time to deal with than day traders, they may benefit more from crossover strategies.
Long-Term Investing with EMA
As for the long-term traders, since their goals lie in the long run, their EMA time frames can be longer too, like a 200 EMA time frame, which is quite popular. The strategies that would suit such goals include death and golden crosses.
Advantages and Limitations of EMA
But as with any indicator within the stock market, you have both the pros and the cons. Understanding both can be beneficial, as it will allow you to make up for the limitations, effectively making the most use out of it.
Benefits of Using EMA
The pros regarding the EMA indicator have to do with its faster responsiveness to price changes, how smooth its trend lines can be, and the flexibility and versatility it possesses for different time frames.
All this combined can make for a worthwhile tool that is sure to be incorporated within many traders’ strategies.
Limitations of EMA
As for the cons, it should be noted that EMAs are a lagging indicator in that despite how fast it can be, it cannot exactly stay toe to toe with the actual price itself, and sometimes you’ll find a delay in the identification of up or down trends.
Besides that, it’s not particularly good within choppy markets, and the potential for false signals is really there.
And finally, it’s not that effective in markets where there’s too much action, as in extreme volatility, and this is where its nature as a lagging indicator can truly be felt.
Conclusion
EMAs are extremely well-known among traders since this indicator gives more weight to the latest prices and is generally faster than other moving averages.
It’s typically used within stock trading to help traders assess the situation and know when to enter or exit. But like with any other indicator, the EMA is best used with other trading tools.
That way, they could make up for its limitations and make the most use out of it.
What is the difference between EMA and SMA?
EMA emphasizes the recent prices or data more, whereas the SMA focuses equally on every piece of data, old and new, to reach conclusions that traders may use to their benefit.
What is the best period setting for EMA?
The best period setting is largely dependent on you as a trader and your requirements. Are you a swing trader or a day trader? Or do you prefer trading with the long term in mind? Asking yourself questions like this will help determine the optimal time frame.
Can EMA be used for all asset classes?
It could be used for every asset class, technically speaking, though its usage would vary tremendously. It wouldn’t do well in markets with flat prices, nor would it be suitable for extreme volatility, as both of these circumstances can raise the possibility for false signals.
How can I avoid false signals with EMA?
You can avoid false signals by just combining it with other indicators like the RSI or MACD for additional confirmation.
Is EMA effective in volatile markets?
That would depend on the degree of volatility. Some is needed to achieve optimal functionality, as you can’t expect an indicator like that to be suited for flat markets. However, too much can be bad too.
