Exponential Moving Average (EMA) is a lagging indicator. An Exponential Moving Average (EMA) is a type of moving average that gives more weight to the recent prices of a stock or an underlying asset. It is a technical indicator which helps a trader to keep track of the trend and momentum of the market. Unlike a simple moving average (SMA), which assigns equal weight to all prices in a period, an EMA reacts faster to the changes in prices and follows them more closely.
There are Three types of Moving averages:
- Simple Moving Average
- Exponential Moving Average
- Weighted Moving Average
What is EMA in Stocks and How do they Work?
EMAs are commonly used by traders to analyze and confirm their trades. Slopes in the EMA charts signal the uptrend or downtrend of a stock. The best way to predict a possible stock price reversal is by comparing the exponential moving average (EMA) and the simple moving average (SMA) on a price chart. The point at which the long-term SMA and short-term EMA intersect is when the recent price trend is reversing.
One of the most commonly used EMAs are 50-day, 100-day, and 200-day EMA which provide the resistance and support levels of stock. The support level is the point when the stock price begins to rise, whereas the resistance level is the point when the stock price begins to fall. When the price breaks the trend line, is the most optimal time to enter a trade with several other confirmations.
To understand it more deeply here is the breakdown of EMA:
- Same rules are applied to EMA that are applicable on the SMA. The difference is that the EMA is significantly more sensitive to price movements. This can be both, good and bad. On one side of the coin, an EMA can help you in identifying trends earlier as compared to a SMA would. On the other hand, it will possibly experience more short-term variations than its corresponding SMA.
- Using the exponential moving average (EMA) to determine trend direction can help a trader to identify trend based opportunities. One should consider buying a stock when the EMA rises and the price drops just below the EMA or is near it. Inversely, sell a stock when the EMA falls, and the prices rally near the EMA.
- As mentioned above, moving averages also act as support and resistance areas. A rising EMA leans towards supporting the price action, whereas a falling EMA leans towards providing resistance to price action. This trading strategy of buying stock when the price is near the rising EMA and selling stock when the price is near the falling EMA is one of the most common ways most of the traders use.
- Moving averages, including EMA, are not created to identify trades at the exact bottom and top. They might be helpful to trade in the general direction of a trend, but with a delay at entry and exit points since it is a lagging indicator. However, the EMA has a shorter delay than the SMA in the same period.
How To Calculate EMA?
In order to calculate EMA you need to understand that how SMA is calculated. Suppose you want to use a 20-day EMA, then you have to wait till the 20th day to obtain the SMA. Consequently, on the 21st day, you can then use the SMA from the previous day as the first EMA.
SMA calculations are rather straightforward – the sum of the stock closing prices during a certain period, divided by the number of observations for that period. Explained simply, a 50-day SMA is the sum of the closing prices for the past 50 trading days, divided by 50.
In the next step, calculate the multiplier for smoothing (weighting) the EMA:
[2 ÷ (number of observations + 1)]
For a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952. Going forward, use the following formula to calculate the current EMA:
EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)
The EMA gives higher weightage to recent prices, while the SMA gives equal weight to all values. The weightage given to the most recent price is greater for a shorter-period EMA as opposed to a longer-period EMA. There also exist variations of the exponential moving average, computed by using the open, high, low, or median price instead of using the closing price.
Conclusion
EMA is used by the majority of the traders. Even though EMA is a lagging indicator it is highly useful to identify the trends and to filter out your trades. It is generally used to avoid false breakout. Usually profitable traders don’t punch trades only on the basis of the indicators; they usually use indicators to filter and confirm their price action analysis.