Moving averages are indicators used in technical analysis to check the average price movement of securities over time. It is calculated from the total of closing prices of a specified period. Moving averages help in determining market trends and spot resistance and support levels. There are three types of moving averages:
1. Simple moving average
2. Exponential moving average
3. Weighted moving average
What is an exponential moving average?
The exponential moving average or EMA gives higher weightage to more recent data points. As compared to a simple moving average, an exponential moving average reacts more significantly to recent prices changes. The most popular short term averages are the 12-day and 26-day EMA. For the long term trends, the 50-day and 200-day EMAs are used. If at any point the stock price inches past the 200-day EMA or makes a cross sign, it is an indication of a reversal that has occurred. The more extended period taken for the EMA, the lower is the relative weighting for recent trading.
What is EMA in stocks?
In stock markets, EMAs are used for analysis and as a trading signal. Slopes in the EMA charts show the uptrend or downtrend of a stock. The 50-day and 20-day EMA charts give the resistance and support levels of stock. The support level is the point at which the stock price begins to fall, while the resistance level is the point at which the stock price begins to rise. A prime time to enter a trade is when the price breaks the trend line.
The EMA can be used to provide a trade direction. You may consider buying a stock when the EMA rises and the prices drop just below the EMA or are near it. Similarly, you could sell a stock when the EMA falls, and the prices rally near or just above the EMA.
The best way to judge a possible turn in stock price is by plotting the EMA and the simple moving average (SMA) on a price chart. The point where the long term SMA and short term EMA cross is when the recent price trend is reversing.
EMAs are also used with other indicators such as Keltner Channels to give buy signals.
Formula for EMA:
You can use the formula to calculate EMA:
EMA = (Value today *(Smoothing / 1 + Days)) + (EMA yesterday * (1 – ( smoothing / 1 + days))
To calculate EMA, you have first to calculate the SMA and smoothing/weighted multiplier of previous EMA. SMA is the total of the closing prices of a stock over time, divided by the same number of days. For example, the SMA for 20 days is the total sum of the closing prices in the last 20 trading days, divided by 20.
You can calculate the multiplier for smoothing (weighting) the EMA with the given formula:
[2 / (selected time period + 1)]
Therefore, for the same 20 day period, the multiplier would be [2 / (20 +1)]. This is equal to 0.0952.
You can then calculate the EMA by using the formula:
[Closing price – EMA (previous day)] x multiplier + EMA (previous day)
Difference between EMA and SMA:
The SMA gives equal weighting to all values, while the EMA provides a higher weighting to the most recent values. As EMA places more weighting on current data points, the EMA is more sensitive to the latest price changes as compared to an SMA. This ensures the results from the EMA are more timely, making it more popular among traders.
As EMA depends on historical data, many economists have argued its efficiency. They believe, current prices reflect the actual information about the asset, and therefore, historical data will not be able to provide a future direction.
Some economists also argue that emphasising only on recent days limits the EMA and makes it biased.
EMAs are used for technical analysis, but it can be dangerous if misinterpreted. Also, moving averages do not tell us the exact top or bottom of a trade, but help us to judge the general direction.