What is the Exponential Moving Average (EMA) in Trading

Disclaimer: This post is not meant to serve as financial advice. It is only meant for information and educational purposes. Nullbeans.com, its owners and writers are not financial advisers and are not responsible for any financial decisions or actions you or others perform due to information in this post.


In this post, we will discuss what the Exponential Moving Average (EMA) is and how is it used when trading stocks, commodities or currencies. If you are new to moving averages, then I highly recommend that you first read our article about “Simple Moving Average (SMA) in Trading” in order to better understand the contents of this post.

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What is the Exponential Moving Average (EMA)

The Exponential Moving Average or EMA for short is a technical indicator used in chart analysis. Like the SMA, the EMA is also a moving average. This means that it’s value is based on the calculation of the average closing prices of the past. How far in the past usually depends on your calculations. For example, the 200 Day EMA takes into consideration the closing prices of the last 200 days.

Unlike the SMA, the EMA provides a larger weight to more recent price values than older ones. For example, when calculating the 200 day EMA, yesterday’s price has a larger weight in the calculation than the price of the day before yesterday, and so on.

Why would this benefit us during chart analysis? Remember when we mentioned that the simple moving average is a lagging indicator? Well, the EMA tries to be “less lagging” by providing larger weight to more recent values during calculations. This means that if a recent price spike up happens, the EMA line will more likely to move upwards that the SMA and vice versa.

Take for example the following chart.

SMA: Green line
EMA: Yellow Line
Click to enlarge


As you can see from the chart, when large price spikes or dips occur, the EMA changes it’s direction faster than the MA. This makes the EMA more sensitive to price action which makes it more ideal for making shorter time trades than the SMA. However, it also means that it can produce more false signals.

EMA trading signals and strategies

Just like the SMA, the EMA can provide us useful information about upcoming support and resistance levels. Let us discuss these signals in the coming sections.

EMA as short term support and resistance

The EMA can be a very useful indicator if you are looking for short term support and resistance levels. This is because the EMA reacts quickly to market movements. Also note that support and resistance levels are extremely useful for identifying entry and exit points of the market.

Take for example the following chart. Here, we will use the 21-day EMA to find the short term support and resistance levels. Note that the 21 (hour/day/week…) EMA is often used by traders, which is why we use it here in our examples.

Click to enlarge

Notice how the EMA “hugs” the price levels. However, it still does act as a resistance line, until the resistance is broken. Then it continues to act as support for the next few months before the market trend changes again.

We can learn from this chart two things:

  • When the market is trending lower and the EMA is above the price action, then we can look for short/sell opportunities when the price is close to the EMA.
  • When the market is trending higher and the EMA is below the price action, then we can look for buy/long opportunities when the price is close to the EMA.



Market trend reversals

In the previous chart, we demonstrated how to identify entry and exit points using the EMA. However, prices will not stay forever under or over the EMA.

So how can we tell if the EMA support/resistance line will hold? Well, we can’t, but we can increase our chances of success.

Let us revisit the previous chart. Between the months of June and July we notice that the trend is reversing from a downtrend to an uptrend. How could we tell if a reversal is going to happen? One way to do so is to look for convergences and divergences using the RSI. We discussed this technique in more detail in our articlehere.

If we observe carefully, we could see that as the prices were trending lower just before the trend reversal, the RSI was trending higher.

Click to enlarge


As we can see from the chart, just before the trend reversal, a bullish convergence occurred. Whenever we see a divergence, we need to be extra careful before making any moves, as divergences and convergences usually indicate that a trend reversal is around the corner.

We can also learn that the EMA indicator, like any other indicator, should not be used alone, but should be used alongside other indicators.

So to summarize, combining a divergence or convergence signal on the RSI along with price action moving and staying above or below the EMA line is a strong indicator of a trend reversal.

Be careful during non-trending markets

When the market is neither trending upward nor downward, the EMA can lose its value in support and resistance. Take the following chart for example.

Click to enlarge


We can see that the EMA is being crossed often on the chart, neither serving as support nor resistance. We could still trade the swings as there is a high probability that the price would return to the 21-day EMA. However, it is risky business. You have been warned.

Summary

In this tutorial, we discussed what the EMA is and how it differs from the SMA. We discussed some strategies for how to use the EMA to our advantage during trading. To summarize:

  • The EMA moves faster than SMA.
  • The EMA can act as support and resistance.
  • The EMA can be combined with divergences in the RSI to identify trend reversals.
  • The EMA should not be used alone and should be combined with other indicators.
  • The EMA may not be useful during non-trending markets (when the price is going sideways)


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What is the Exponential Moving Average (EMA) in Trading

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