How to use a moving average or an expontetial moving average

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Exponential Moving Average: what is it and how to use it

As you become a more experienced investor, you will want to use in-depth tools to analyse when to get in and out of trades – and one of the most useful ways of doing this is through the exponential moving average indicator, or EMA.

If it sounds too technical, don’t panic – it’s actually quite simple to use in practice, and is basically just a refinement of the simple moving average (SMA).

Let’s just recap how a simple moving average works. This gives you the average price of a stock over a set number of days, depending on your investment horizon –whether you’re a short-term or a long-term investor.

It can help cut through the noise on a stock chart by showing long-term trends as a single line.

As the name suggests, it changes every day – so if it’s a 50-day moving average, on day 51, the original day 1 drops off the calculation and is replaced by the new figure.

Reflects recent data

The EMA works in exactly the same way, but reflects the most recent data more closely. While the SMA can often lag the market – meaning you could miss the optimal point to open a trade – the EMA will show these signals more accurately.

To arrive at your EMA, you start by calculating your SMA, which is a simple average calculation – add the figures together and divide by the number of numbers used.

For example: 10-day SMA = sum of figures ÷ 10

You then add a weighting that reflects the bias you want to give to the most recent prices, creating a weighted moving average with the emphasis on the most recent prices.

A typical 10-day EMA adds an 18.18% weighting to the most recent price, while a 20-day EMA applies a 9.52% weighting.

The moving average formula goes something like this:

EMA weighting = multiplier (2) ÷ time period +1 (10+1) = 0.1818 (known as k)

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And to calculate the EMA: EMA = price today x k + yesterday’s EMA x (1-k)

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If all these formulae are making your head spin, the good news is that most trading platforms offer charts that do it all for you, and you can simply overlay your chosen formula on the live stock chart.

While exponential moving averages are good for spotting sudden shifts in price movements, they are less accurate than SMAs when charting long-term trends. They are also not as good at identifying levels of support or resistance (see article on simple moving averages). By weighting for recent price movements, an EMA indicator could also tip you out of a trade sooner than you wanted if a stock has a short-term blip.

The EMA indicator can be taken one stage further to calculate the moving average convergence divergence (MACD) oscillator. This was developed by Gerald Appel in the 1970s and shows the relationship between two sets of moving averages.

The MACD subtracts the longer-term EMA from the shorter-term EMA to produce a trace that reflects both trend and momentum.

A typical setting subtracts the 26-day EMA from the 12-day EMA, which is plotted on the graph. A nine-day EMA, known as the signal line, is then laid on top, and can show potential buy and sell signals.

Crossovers and divergence

As with the simple moving average, you can use the MACD to look for crossovers and divergence.

If the MACD falls below the signal line, it’s a sign of bearish movement, and could be a sell signal. Equally, if the MACD rises above the signal line, it’s a bullish sign, and could suggest it’s the right time to buy.

When the stock price diverges from the MACD, it usually shows the end of a trend. If the price is falling and the MACD is going up, it’s a bullish sentiment that suggests a downward trend is about to end.

If the stock price is rising and the MACD is falling, that suggests a rally may be about to come to a halt.

A dramatic rise in the MACD, where the shorter moving average rises rapidly above the longer term EMA, is a sign the stock has been overbought and will soon fall back to normal.

An important thing to remember about both SMAs and EMAs is that because so many traders use them, they become a self-fulfilling prophecy – so if it’s giving a ‘buy’ or ‘sell’ signal, don’t try to buck the trend, or you could get your fingers burned.

Exponential Moving Average (EMA): A Pillar of Technical Analysis

By NinjaTrader | April 20, 2020

Exponential moving averages (EMA) are designed to analyze financial instruments’ price movement. The difference between EMAs and other moving averages is that EMA’s apply a higher value to more recent data points. For example, a 14 day EMA will value the most recent 5 days more than the least recent 5 days of data.

Learn more in this quick video:

Below, you can see a 14 day EMA over the EUR|USD on a foreign currency trading chart:

Trading a Bullish Buy Signal Using an Exponential Moving Average

When the price action of a financial instrument convincingly breaches an exponential moving average during a bearish trend, a bullish trend reversal may occur in the near future. A bullish breach of the EMA can also be looked at as a potential buy signal. Once the trend is breached for a second consecutive time, but to the downside, it could be identified as an exit or sell signal.

Trading a Bearish Sell Signal Using an Exponential Moving Average

When the price action of a financial instrument convincingly breaches an exponential moving average during a bullish trend, a bearish trend reversal may occur in the near future. A bearish breach of the EMA can also be looked at as a potential sell signal. Once the trend is breached for a second consecutive time, but to the upside, it could be identified as an entry or buy signal.

How EMA’s Are Used with Other Technical Indicators

Exponential moving averages can also be used in tandem with other technical indicators such as Bollinger Bands®. The most common exponential moving average used with Bollinger Bands® is a 21 day EMA. The 21 day EMA is surrounded by the upper and lower band in order to provide a reference point of past and present price action.

Additionally, the 21 day EMA is used as a technical trading indicator of future price action. If the Bollinger Bands® tighten around the EMA, this could be identified as a low volatility period with a potential price move likely in the near future. If the Bollinger Bands® loosen around the EMA, this could be identified as a high volatility period with a potential price move not likely in the near future.

Looking at the EUR|USD chart below, the 21 Day EMA is located between the upper and lower Bollinger Band®:

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Simple, Exponential, and Weighted Moving Averages

Day Trading Uses and Applications of Moving Averages

Moving averages act as a technical indicator to show you how a security’s price has moved, on average, over a certain period of time. Moving averages are often used to help highlight trends, spot trend reversals, and provide trade signals. There are several different types of moving averages, but they all create a single smooth line that can help show you which direction a price is moving.

Simple Moving Average Calculation

The simple moving average (SMA) calculates an average of the last n prices, where n represents the number of periods for which you want the average: 

Simple moving average = (P1 + P2 + P3 + P4 + . + Pn) / n

For example, a four-period SMA with prices of 1.2640, 1.2641, 1.2642, and 1.2641 gives a moving average of 1.2641 using the calculation (1.2640 + 1.2641 + 1.2642 + 1.2641) / 4 = 1.2641.

While knowing how to calculate a simple average is a good skill to have, trading and chart platforms calculate this for you. Simply select the SMA indicator from the list of charting indicators, apply it to the chart, and adjust the number of periods you want to use.

You typically make adjustments to the indicators in the Settings menu section of a trading platform. On many platforms, you can locate the settings by double-clicking on the indicator itself.

The advantage of an SMA is that you know exactly what you are getting. The SMA value equals the average price for the number of periods in the SMA calculation.

Common SMA values are eight, 20, 50, 100, and 200. For example, if using a 100-period SMA, the current value of the SMA on the chart is the average price over the last 100 periods or price bars.

This chart shows a 50-period SMA, along with an exponential moving average (EMA) and a weighted moving average (WMA) on a one-minute stock chart. Due to their different calculations, the indicators appear at different price levels on the chart.

Exponential Moving Average Calculation

The exponential moving average (EMA) is a weighted average of the last n prices, where the weighting decreases exponentially with each previous price/period. In other words, the formula gives recent prices more weight than past prices. 

Exponential moving average = (Close – previous EMA) * (2 / n+1) + previous EMA

For example, a four-period EMA with prices of 1.5554, 1.5555, 1.5558, and 1.5560, with the last value being the most recent, gives a current EMA value of 1.5558 using the calculation (1.5560 – 1.5558) x (2/5) + 1.5558 = 1.55588.

As with the SMA, charting platforms do all the EMA calculations for you. Select the EMA from the indicator list on a charting platform and apply it to your chart. Go into the settings and adjust how many periods the indicator should calculate, such as 15, 50, or 100 periods.

The EMA adapts more quickly to price changes than the SMA. For example, when a price reverses direction, the EMA will reverse direction quicker than the SMA. This takes place because the EMA formula gives more weight to recent prices, and less weight to prices that occurred in the past.

Weighted Moving Average Calculation

The weighted moving average (WMA) gives you a weighted average of the last n prices, where the weighting decreases with each previous price. This works similarly to the EMA, but you calculate the WMA differently. 

Weighted moving average calculation = (Price * weighting factor) + (Price previous period * weighting factor-1)

WMAs can have different weights assigned based on the number of periods used in the calculation. If you want a weighted moving average of four different prices, then the most recent weighting could be 4/10, the period before could have a weight of 3/10, the period before that could have a weighting of 2/10, and so on.

The “10” in that scenario is a randomly chosen number. A weight of 4/10, for example, means the most recent price will account for 40% of the value of the WMA. The price three periods ago only accounts for 10% of the WMA value.

For the following example, assume prices of 90, 89, 88, 89, with the most recent price first. You would calculate this as [90 x (4/10)] + [89 x (3/10)] + [88 x (2/10)] + [89 x (1/10)] = 36 + 26.7 + 17.6 + 8.9 = 89.2

You can customize the weighted moving average more than the SMA and EMA. The most recent price points are usually given more weight, but it could also work the other way, where you give historical prices more weight.

Moving Average Trading Uses and Interpretation

Moving averages can be used for both analysis and trading signals.

For analysis, all the moving averages help highlight the trend. When the price is above its moving average, it shows that the price is trading higher than it has, on average, over the period being analyzed. That helps confirm an uptrend. When the price sits below its moving average, this shows that the price is trading lower than it has, on average, over the period being analyzed. That helps confirm a downtrend.  

When the price crosses above its moving average, this shows the price is getting stronger relative to where it was in the past because the most recent price now sits higher than the average. If the price crosses below its moving average, it shows the price is getting weaker relative to where it was in the past. 

One longer-term and one shorter-term moving average—for example, 20 and 50 periods—can be added to a chart simultaneously. When the 20-period moving average crosses above the 50, it indicates that short-term price momentum is moving to the upside. When the 20-period moving average crosses below the 50, it indicates that the short-term price momentum is moving to the downside.

Moving averages can also be incorporated with other indicators to provide trade signals. An EMA can provide buy signals when combined with Keltner Channels. A strategy may include buying near the EMA when the trend is up and the price is pulling back from the top of the Keltner Channel. 

One type of moving average isn’t inherently better than others; they just calculate the average price differently. Depending on the strategy you’re using, one type of moving average may work better than another. Try out different moving average combinations and see which provides you with the best results.

You may find that, for each market, you need to adjust your settings slightly. A 50-period SMA may provide great signals on one stock, for example, but it doesn’t work well on another. Or a 20-period EMA may help isolate the trend on one futures contract, but not another. All the moving averages are just tools, and interpreting them is up to the trader because no indicator works well all the time or in all market conditions.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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