As you embark on your trading journey, you need to have the right tools that'll help you make better decisions.
And mastery of each of your tools is vital to your success.
So, here's another to add to your trading toolbox: the exponentially weighted moving average.
What's the EMA?
The Exponential Moving Average or EMA is a modification of the Simple Moving Average.
It's a technical indicator that exhibits almost the same functions as the SMA, and its calculation is virtually similar except for the extra weight placed on the most recent price data.
This extra weight is to place more importance on the latest price making the Moving Average more reactive to the new price information.
As with the SMA, the EMA is utilized by traders for the following purposes:
1. Indicate a change in trend
A change in trend happens when a cross between a fast MA and a slow MA occurs. A fast MA is one with fewer closing prices like a 10-day MA, for example. A slow MA, on the other hand, averages more closing prices, e.g., 100 or 200-day MA.
The example below shows a 10-day EMA plotted by the red line and the 100-day EMA plotted by the blue line.
2. Spot Support and Resistance Levels
According to John Magee and Robert D. Edwards in their classic book Technical Analysis of Stock Trends, moving averages were initially intended to be used as automated trend lines. This remains true today.
The crosses between prices and the moving averages create areas on the chart that can be inferred as dynamic support or resistance levels.
3. Determine market condition
The market condition, whether it's bullish, bearish or sideways, can be determined by understanding how the price and the Moving Average are situated from one another on the chart.
4. Signal trading opportunities
And, finally, as with indicating a shift in trend, trading opportunities can also be spotted from the crossover between multiple moving averages.
How to Calculate the EMA
To calculate the EMA, follow these steps:
Here's how to calculate the EMA on Excel:
Exponential Moving Average vs. Simple Moving Average
The main difference between the EMA and the SMA is that the EMA is more sensitive to the latest price data, so, in a chart, you'll see it slither closer to the price.
The benefit of that is it can catch a change in trend faster than the SMA. Take a look at the image below.
As you can see from this EUR/USD chart, the 50-day EMA line (blue) was able to signal bearish or bullishness faster than the 50-day SMA (red). And, that occurred three times in seven months.
However, this difference is very minimal, especially with higher time periods.
For the sake of simplifying the analysis, some traders would make use of the SMA instead, or add more weight to the closing prices than the standard EMA calculation adds.
EMA False Signals
The EMAs' capacity to catch moves quicker than the SMA is also its downside. Since moving averages only present probabilities, the new price might be a mere surprise reaction to fundamental data, and the EMA is more susceptible to capture it.
How to add the EMA on MetaTrader
To add the EMA on your MetaTrader 4 platform, follow these steps:
Remember that the EMA is only a technical indicator, and it only suggests where the market currently stands or if there is a possible change to it. Therefore, to think that it'll guarantee you consistent positive results is an entirely misguided view. Again, echoing the message at the beginning of this article, mastering the trading tools like the EMA is just to aid you in your decision making.
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