What are Exponential Moving Averages?
Exponential Moving Average (EMA) is a trend-measuring indicator known to respond faster to recent price changes than any other Moving Average. The indicator gives more weighting to recent price data than any other data regardless of the period of use.
Just like other moving average indicators, EMA is best suited for trending markets, moving either up and down. If the market is in a sustained uptrend, then an EMA trend line will also appear in an uptrend. On the flip side, it will trend lower when prices decrease.
Calculations of EMA
Exponential Moving Average uses all price data within its current value but pays more attention to the most recent data. In this case, the most recent price data has more impact on the indicator, while the oldest price data has the least impact.
EMA= (K X(C-P) +P
Where C= Current Price
P= Previous periods EMA
K= Exponential smoothing constant
Exponential Moving Average differs from the Simple Moving Average in that it pays more attention to the most recent price data. By focusing on recent price data, the indicator can provide more accurate information of what is happening in the market in real time than the SMA does. The indicator also follows prices more closely than the SMA, which tends to have a bigger lag.
The fact that the indicator is price sensitive makes it a double-edged sword. While the exponential moving average indicator can help identify trends earlier than usual, it is usually subject to more short-term changes than the SMA is.
The 12- and 26-day exponential moving averages are the most popular when it comes to short-term technical analysis. Similarly, the 50-day and 200-day lines are popular exponential moving averages when it comes to analyzing long-term trends.
How to use the Exponential Moving Average
A closer look at the chart above shows that the 10EMA responds more quickly to price reversals than the 10SMA, which tends to lag behind. For this reason, Exponential Moving Averages are viewed as better than Simple Moving Averages given their ability to respond quickly to price changes.
One of the best ways to use exponential moving averages in technical analysis is by using a double EMA combination. In this case, one can insert short-term and long-term exponential moving averages to leverage the crossover strategy in entering and exiting positions.
For long-term traders, one can use a 25 EMA as the short-term moving average and a 100-day EMA as the long-term moving average. In this case, you can look for buy opportunities whenever the short term 25-day EMA crosses the long term 100-day EMA from below. Similarly, one can look for sell opportunities whenever the short-term EMA crosses the long-term 50-day EMA from above.
Using EMA with Other Indicators
Exponential Moving Averages, like other indicators, should never be used in isolation. Instead, any indicator should always be paired with another indicator as part of any trading strategy. For instance, one can accompany an EMA indicator with an oscillator indicator such as RSI to avoid the temptation of buying in overbought or oversold environments.