EMA explained: Trading with exponential moving averages

What does EMA stand for?

EMA stands for exponential moving average. It’s a simple indicator that charts the price of a security over time. EMAs are often calculated in 10, 50 and 200-day moving averages. These modified moving averages can be used for any asset including stocks, forex, and indices to track price trends and confirm entry and exit points for your trading strategy.

All moving averages are lagging indicators, so the EMA should not be used to produce trading signals alone. Entry and exit points revealed by moving averages are often delayed. So many traders use EMAs for confirming signals identified by other, faster indicators.

EMA vs SMA

The exponential moving average is a variation on the simple moving average. In calculating its average, the EMA gives greater weight to recent prices, while an SMA gives equal weight to all price data.

Because of the difference in weight, the EMA tends to follow the real price level more closely than the SMA does. It also responds faster to changes in value. While this allows the EMA to identify trends earlier than the SMA does, it can also be more likely to experience false signals.

How to calculate an EMA

To calculate an EMA, you first need the closing price for each period you intend to include in the average. So, a 20-day EMA will require the closing price of that asset for the past 20 days. Then, you calculate the SMA for those 20 days. To do this, add all 20 closing prices and divide by 20.

In order to change the SMA into an EMA, you introduce a multiplier which determines the weight given to the most recent data point. The multiplier for a 20-period EMA = 2 / (20 + 1). Now, on the 21^st day, you can calculate the EMA with this formula:

EMA = (closing price – previous EMA) x multiplier + previous EMA

Multiplier = 2 / (n +1), where n = the number of periods calculated.

EMA calculation example

Here is an example of calculating a 20-day EMA where the previous day’s 20-day SMA is 50 and the current closing price is 52.

The multiplier is calculated as 2 / (20 + 1) = 0.0952

The EMA = (52 – 50) x 0.0952 + 50 = 50.19

So, the next day’s EMA = 50.19

How is EMA used in trading?

The EMA is used in trading to identify buy and sell signals as well as ongoing trends. These signals appear in crossovers and divergences from the price action or other moving averages.  Keep reading to learn different ways exponential moving averages can be used in trading.

It’s important to note again that moving averages are lagging indicators, so they are best used to confirm other signals. You should not execute trades based solely on lagging indicators. Entering a trade based on lagging indicators may cause you to miss the window of profitability and lose money.

Identifying trends

You can use the EMA to identify trends by simply watching the direction of the indicator. A rising EMA signals a long trend, and a falling EMA signals a downtrend.

Moving averages are best used to confirm trends signaled by leading indicators like the RSI and stochastic oscillator. If a trend identified by those indicators is also confirmed with your EMA, you have a stronger signal. If the trend is disproved by your EMA, you can either avoid the false signal or close your already opened trade with minimal losses.

While moving averages can be calculated with any number of points, the 12 and 26-day EMAs are most common for finding short-term trends. These EMAs are used in other indicators like the moving average convergence divergence (MACD) and the percentage price oscillator (PPO). Longer EMAs utilizing 50 and 200-day timeframes are best geared towards finding longer-term trends. For example, when a market’s price crosses its 200-day EMA, it is believed to signify that a reversal has occurred.

Identifying support and resistance

When price is trending in one direction, the EMA functions as a level of support or resistance you can use to open trades. Because moving averages are lagging indicators, the price of a bull market will sit above the EMA (and bear market price action will rest just below the EMA).

When the price is rising, you can open a long position when the price dips near or at the indicator, functioning as the level of support. For a downtrend EMA, you might consider opening a short position when the price rises to meet the EMA as a level of resistance.

Identifying crossovers and reversals

When the EMA fully crosses the average price action, a reversal is indicated. If the EMA crosses above the price in a downtrend, a bullish reversal has occurred. If the price crosses below the EMA in an uptrend, a bearish reversal has occurred. In these cases, the price is breaking the level of support and resistance represented by the EMA.

You can also use multiple moving averages to identify price reversals. By displaying a short and long moving average or an exponential and simple moving average, the two are expected to indicate changes in price direction when they cross. This is because shorter MAs and EMAs react faster to price swings than long and simple MAs. These types of reversals are named the golden cross and the death cross.