What is Exponential Moving Average (EMA) & How it is Calculated?

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))

How to Calculate EMA?

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)

What Does EMA Tell You?

The financial world can be a whirlwind of price movements. But fear not, traders! The Exponential Moving Average (EMA) is here to help. It acts as a compass, providing valuable insights into market trends.

Unlike a simple moving average (SMA) that equally weights all prices in a period, EMA gives more importance to recent data. This makes it more responsive to current market conditions. Imagine a price chart with frequent ups and downs. SMA would smooth out the bumps, but EMA would hug the trend line more closely.

The choice of EMA length significantly impacts the information it reveals about the market. Here’s a breakdown of some frequently used EMA lengths and their applications:

Short-term EMAs (12-25 days): These EMAs react quickly to price changes and are often used to identify short-term trends and trading signals. They can be instrumental in technical indicators like Moving Average Convergence Divergence (MACD) and Percentage Price Oscillator (PPO). However, due to their sensitivity, they can also generate more frequent buy-and-sell signals that may not be ideal for all trading styles.
Long-term EMAs (50-200 days): These EMAs place more emphasis on historical data, smoothing out short-term volatility and providing a clearer picture of long-term trends. They are helpful for gauging the overall market direction and identifying potential support and resistance levels. Because they react slower to price changes, they may not be suitable for capturing short-term opportunities.

So overall, what exactly does EMA tell you?

Direction of the Trend: An upward-sloping EMA suggests a bullish market, while a downward slope indicates a bearish trend. This helps you understand the overall sentiment and make informed decisions.
Trend Strength: The steeper the EMA slope, the stronger the trend. A gentle slope suggests a possible trend change or a period of consolidation.
Early Trend Identification: Due to its focus on recent data, EMA can pick up on emerging trends faster than SMA. This allows you to potentially capitalize on opportunities before they become mainstream.

However, EMA isn’t a crystal ball. It’s a lagging indicator, meaning it reacts to past price movements. It can also be more volatile due to its sensitivity to short-term fluctuations.

By combining EMA with other technical indicators and fundamental analysis, you can gain a more comprehensive understanding of the market. Remember, EMA is a powerful tool, but it’s best used in conjunction with other strategies for successful trading.

Difference between EMA and SMA

Both EMA and SMA are technical analysis tools used by traders to identify trends and smoothen out price fluctuations in the market. While they share some similarities, there are key differences in their calculations and how they react to price movements:

Weighting of Price Data: SMA treats all price points within a chosen period equally when calculating the average. EMA, on the other hand, assigns greater weight to more recent prices, making it more responsive to current market conditions.
Reaction to Price Changes: Due to the emphasis on recent data, EMA reacts faster to price swings compared to SMA. This can be beneficial for identifying emerging trends early on. However, it can also lead to more signal noise due to short-term volatility.
Accuracy and Usability: Although a 10-day EMA can be calculated with 10 days of data, a longer timeframe is generally recommended for a more reliable representation of the trend. SMAs tend to be less sensitive to short-term fluctuations, making them potentially useful for confirming trends identified by EMA or for longer-term analysis.

In conclusion, both EMA and SMA offer valuable insights for traders. EMA provides a quicker response to price changes, while SMA offers a smoother trend indication. Choosing the right indicator depends on your trading goals and risk tolerance.

EMA limitations

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 emphasizing only on recent days limits the EMA and makes it biased.

Conclusion

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.