Exponential Moving Average: Meaning, Benefits & Drawbacks
Trading and investment in various asset classes can be a complex task due to inherent challenges like volatility in asset prices, overall macroeconomic situation, etc. In this regard, you can always rely on several technical indicators to take profitable positions.
An exponential moving average (EMA) is one such technical indicator that analyses various data points and provides conclusive results about investment in a particular asset. It relies on recent price points, i.e., it gives more weightage and significance to recent data points. Let’s discuss various working aspects of this concept and how it can help you in booking a gainful trade.
What Is Exponential Moving Average?
Also called weighted exponential moving average, EMA shows greater sensitivity towards recent price changes. It operates differently from a simple moving average which gives equal weightage and representation to all historical price points. Therefore, we can safely conclude that exponential moving average is more efficient as it gives more emphasis to recent happenings.
It generates buy and sell signals based on divergence and crossovers from historical mean value. There are different exponential moving averages that you can use for technical analysis of an asset, and it includes a 10-day moving average, 50-day moving average, 100-day moving average, etc.
Now that you are well aware of the meaning of exponential moving average let’s shift our focus to other dimensions.
How Does the Exponential Moving Average Work?
The main objective of all moving averages is to set up a direction in which the price of an asset will move depending on its historical price points. As it is more sensitive to recent price changes, it will help you to identify impending trends earlier. At the same time, it may also experience several short-term changes in its working.
It can also indicate various support as well as resistance areas.
- An increasing exponential moving average will provide support to the price action.
- Whereas a falling exponential moving average will offer resistance to the price actions.
As a result, you can go for buying the assets whenever prices are close to rising exponential moving average. On the other hand, you can sell and close off your position when prices are near declining EMA.
Every moving average, including exponential moving average, cannot recognise a trade at the bottom and top. These allow you to trade in the direction of the prevailing market trend; however, it will occur with a delay at corresponding entry and exit price points. The exponential moving average leads to shorter delays as compared to other technical indicators.
What Is the Formula for Exponential Moving Average?
The formula for exponential moving average is as follows:
Exponential moving average = K * (Current market price – previous EMA) + Previous EMA
Here, K represents the weighting factor for exponential moving average, and K = 2/(n+1), where n is the selected time period.
Previous EMA is the last concluded trading session’s EMA. However, in case of first-time calculations, the previous EMA is the same as the starting simple moving average over ‘n’ periods.
Now, let’s say that you want to calculate the 100-day exponential moving average. Therefore, the value of K, which is the weighting factor, will be 2/(100+1) = 0.019 or 1.9%. By putting the values of current market price and previous EMA, you can calculate the exponential moving average of an asset.
What Are the Benefits of Exponential Moving Average?
Here are some benefits of using exponential moving average:
- Identify the Current Market Trend
One of the major benefits of this technical indicator is that it helps in identifying prevailing market trends. If it moves upwards, it indicates a rising or upward trend. Whereas if EMA is falling, it signals a downtrend trend in the asset.
Moreover, it also allows you to forecast the upcoming behaviour of the asset. If the EMA line is above the asset’s prices, it means that the underlying asset will see a fall in its price. On the other hand, if the EMA line is below the price level, it signals that the underlying asset’s price will rise in future.
- Support and Resistance Bands
Another advantage associated with these moving averages is that they can act as support or resistance bands for the price of concerning assets. The support levels, also known as price floors, are levels below which the price will not fall.
Similarly, resistance bands are predetermined price levels of corresponding assets which act as a price ceiling. This means that prices will not rise beyond this limit.
This technical indicator is quite sensitive to price changes, and as a result, it will give traders quick signals about impending price movement of assets. The exponential moving average will give signals faster than the simple moving average and will give you the first-mover advantage.
What Are the Drawbacks of Exponential Moving Average?
Here are some cons of using the exponential moving average:
- As it gives heavy emphasis and weightage to recent price points, there are chances of it giving false signals, which may cause loss to market participants.
- Market experts believe that financial markets are efficient and progressive. Therefore, we will not gain much insight from tracking and analysing the historical data, and it may not determine the future value of assets.
The exponential moving average is a trading technical indicator used to gauge the future price movements of an asset. It analyses the previous price points and gives an idea about the future trajectory of assets.
However, it is imperative that you consider other technical indicators as well to get confirmatory signals. This is because over relying on one indicator can lead to false signals.
Frequently Asked Questions
What are the applications of Exponential Moving Average?
The exponential moving average helps in gauging particular market trends, i.e., whether there is an uptrend or downtrend in the price of an asset. Another application is that it forms the resistance and support bands which are the ranges between which the price will move.
What is the difference between EMA and SMA?
The simple moving average (SMA) is more applicable for longer time intervals. On the other hand, exponential moving average (EMA) is applicable for short time periods.
What are different types of moving averages?
There are six types of moving averages, namely simple moving average, exponential moving average, weighted moving average, double exponential moving average, triple exponential moving average and linear regression.
What is a good Exponential Moving Average?
If you are a short term investor, consider 8-day EMA, 10-day EMA or 20-day exponential moving average. On the other hand, 50-day exponential moving averages and 100 or 200-day exponential moving averages would work better for long term trades.