Exponential Moving Average

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Description

An exponential moving average (EMA) is a type of weighted moving average. It is also similar to a simple moving average except that the prices are exponentially weighted so that recent price data is given more weight than older price data. This reduces the lag seen in simple moving averages (which represents all price data equally), hence EMAs react more quickly to price changes. During "flat" or "non-trending" markets the difference between the moving averages becomes negligible.

EMAs are calculated by applying a percentage of today's closing price to yesterday's moving average. For example, a 10% exponential moving average would be calculated as follows:

(Today's close x 0.1) + (Yesterday's moving average x 0.90)

The 10% (or 0.1 figure) is an arbitrary factor in this case. This weighting factor is usually calculated by dividing 2 by the time period.

The Bourse calculates the EMA by adding all the prices from a specified period multiplied by weighting factors and dividing by the number of prices within the period you specify.

EMAs are lagging indicators. They are used to emphasise the direction of a trend and to smooth out price and volume fluctuations ("noise") that can confuse interpretation.

Interpretation

EMAs can be compared to the actual price. Each EMA provides a different interpretation on what the security will do. As the period decreases, the sensitivity of the EMA to price changes will increase. However, a shorter period also means that you may have a greater number of false signals.

• If the price moves above the EMA and the EMA is directed upward, it can be considered a bullish (buy) signal.

• If the price moves below the EMA and the EMA is directed downward, it can be considered a bearish (sell) signal.

Valid buy and sell signals are not given when the MA changes direction but price does not move above or below the EMA. Another popular technique used for interpreting EMAs is to compare longer-term and shorter-term EMAs with each other.

• When a shorter-term EMA moves above a longer term EMA and both EMAs are directed upwards, it can be considered a bullish (buy) signal.

• When a shorter-term EMA moves below a longer term EMA and both EMAs are directed downwards, it can be considered a bearish (sell) signal.

Moving averages work best in trending markets. Sideways markets (with no clear upward or downward trends) tend to cause false signals. Analysts often use EMAs with other indicators to confirm price direction. Intersections between EMAs and other indicators can be used to pick trend changes.

Advantages and Disadvantages

The advantage of using EMAs is that they pick up trends more quickly than simple moving averages. Some traders prefer to use EMAs for shorter time periods to capture changes quicker.

The disadvantage of EMAs is that more false signals are likely to be generated. Some investors prefer simple moving averages over long time periods to identify long-term trend changes.

TIPS:

• The trick is to choose appropriate periods. It is wise to test your chosen system extensively on historical transaction data for the security that interests you.

• This type of moving average can also be used to smooth out other indicators. Generally, any indicator that appears as a graph below the price chart can be smoothed using a moving average.