Technical analysis boils down to predicting the future directional movement by studying past market behavior and you would not likely find a better way to assess the market than moving averages.
Today, we are going to take a look at how you can use moving averages to analyze any price chart, different types of moving averages, how to calculate them, and of course, how they measure up to each other in real trading environments.
While there is more than a handful of different types of moving averages, you only need to learn about a few key moving averages in order to successfully use them in live trading. Hence, we will keep our discussion limited to the most useful moving averages, including the simple moving average (SMA), the weighted moving average (WMA), and our favorite – the exponential moving average (EMA).
What is the Exponential Moving Average?
The exponential moving average (EMA) is a variant of moving averages that looks and acts like any other moving average. If you look at a chart with a simple moving average (SMA) and an exponential moving average, you won’t be able to differentiate at first glance.
However, under the hood, there are key differences regarding how the SMA and EMA are calculated.
Let’s say you are trading the daily chart and looking at last month’s price action. Would you agree that analyzing last week’s price action would offer a better understanding of how the market is behaving today, and today’s price action would likely dictate tomorrow’s price action?
Since recent price data plays a more relevant compared to older price data in shaping the market, it is common sense that you should give more weight to recent data.
The exponential moving average (EMA) applies this very notion that traders should pay more attention to the recent price action compared to the old ones. Although most modern charting packages automatically calculates and plots the various types of moving averages on a price chart, it is always a good idea that you know how they are calculated as it helps to increase your understanding regarding why moving averages behave differently.
How to Calculate Exponential Moving Average?
Basically, you need to go through three steps to calculate the exponential moving average for trading any instrument.
First, we need to figure out the simple moving average (SMA). If we want to calculate the SMA of the last 10 days, we simply sum up the values of the last 10 closing prices and divide it by 10 to get the SMA.
Once we have the SMA, next we need to figure out the weighting multiplier for the number of periods we want to calculate for the EMA.
The weighting multiplier is calculated with the following formula:
EMA(current) = ( (Price(current) – EMA(prev) ) x Multiplier) + EMA(prev)
You should always remember that the number of periods will have a profound effect on the weighting multiplier as it places greater importance to the most recent price action.
As we are using 10 days in this exponential moving average example, the weighting multiplier would be calculated like this:
(2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)
Finally, once you have calculated the SMA and weighting multiplier values, you can easily calculate the EMA with the following calculation:
(Closing price-EMA(previous day)) x multiplier + EMA(previous day)
Trading with the Exponential Moving Average
While you can use the exponential moving average many ways, professional traders stick to keeping things simple. There are basically two ways you can use the exponential moving averages in trading: (1) using two different period exponential moving average cross to generate buy or sell signals (2) or a single exponential moving average as a dynamic support/resistance zone.
One of the easiest ways of trading with the exponential moving average would be using two different periods on a price chart and wait for the faster period to cross above or below the slower period.
If you see the faster period EMA crossing above the slower period EMA, from a technical point of view, it indicates bullish momentum in the market. On the other hand, if you see the faster period EMA crossing below the slower period EMA, it would indicate bearish momentum in the market.
In addition to using EMA crosses, we can also use the exponential moving average as a dynamic pivot zone. During an uptrend, major EMA periods like the 50 or 200 period EMAs acts as support and resistance zones.
Generating a Buy Signal while Trading with the Exponential Moving Average
In Figure 1, we have applied a green colored 13 period EMA and a red colored 21 period EMA on the 5-minute chart of the Ford Motor Company (NYSE:F).
As you can see, in the far left, when the green line moved above the red line, the price soon gained bullish momentum and started to move up. If you took this trade on October 8th, you would have easily entered a long order around $14.60 per share and exited the trade near $15.10, with a 50 cent profit on each share you traded.
Generating a Sell Signal while Trading with the Exponential Moving Average
In Figure 2, we have once again applied the 13 and 21 period exponential moving averages on a 5-minute price chart, but this time on Apple Inc (NASDAQ:AAPL) to show that this strategy is instrument independent.
As you can see on the second cross on the chart, when the 13 period green EMA crossed below the 21 period red EMA, the price immediately started to gain bearish momentum.
Although the volatility increased significantly, and even if you entered the market after the bar closed below the downward EMA cross, you would still be able to short AAPL at $109.00 per share and exit near $108.20, making a quick $0.80 profit per share in the process.
Exponential Moving Average Example of Dynamic Support and Resistance
In both Figure 1 and Figure 2, you can see that the price often pulled back towards the 13 and 21 period EMAs and then consolidate.
In Figure 3, you can see that price can find both support and resistance around a major EMA level as well.
Since the EMAs are always moving up or down depending on the price action, these levels act as dynamic pivot zones that you can use to place long or short orders. However, we strongly recommend that you use price action triggers to place the order instead of blindly placing limit buy or sell orders around these lines.
As you can assume by now, both the 13 and 21 are Fibonacci numbers and these two periods are very popular among day traders. Since we utilized 5-minute charts to demonstrate how you can use exponential moving average on real life trades, we used faster period EMAs. If you want to trade the daily or weekly time frames, the 50, 100, and 200 period EMAs would be more suitable for such endeavors.
Why Professional Traders Prefer Using Exponential Moving Average?
When it comes to live trading, professional traders and quantitative analysts tend to favor the exponential moving average (EMA) compared to the other types of moving averages, such as the simple moving average (SMA) and the weighted moving average (WMA).
Compared to using simple moving averages (SMA), the weighted moving average (WMA) offers huge benefits as you can consistently put more importance on the recent price action with the WMA.
However, most beginner traders get confused when it comes to differentiating the exponential moving average (EMA) and the weighted moving average (WMA), because the EMA also uses a weighted formula to calculate the values.
But, there are clear distinctions between the EMA and WMA.
When calculating the weighted moving average, you have to use a consistent weight or multiplier in the formula. For example, the WMA price may decrease by a value of 5.0 for every preceding price bar in the chart to give more weight to the most recent price bar.
By contrast, when calculating the exponential moving average (EMA), the weight or multiplier would not be a consistent one, but it would put more importance to the recent price in an exponential manner. That’s why, the weighting multiplier increases or decreases based on the number of periods or price points.
Therefore, the exponential moving average reacts much faster to the price dynamics and offers a more accurate perception regarding the market compared to the simple and consistently weighted moving averages.
Exponential moving average can be a very powerful tool in the arsenal of a savvy day trader. However, you should remember that price does not react around EMA pivot zones because of any underlying market structures - rather self-fulfilling prophecies.
You see, large hedge fund analysts and other institutional traders often use the major moving average periods to decide if a financial instrument is trending up or down, or just staying within a range. Hence, when a major EMA cross happens or the price approaches these EMAs, where there a lot of traders watching these price levels, they tend to place large quantities of orders around these levels. As a result, when price reaches near these EMAs, the orders get filled and market volatility goes up. Depending on the buy or sell order dynamics around these pivot zones, the price either resumes the trend or changes the prevailing trend altogether.
That’s why, you should always keep an eye on where the major EMA lines are in a price chart regardless if you are using technical analysis or solely depending on fundamental analysis in your trading system.