Exponential Moving Average (EMA) helps in understanding the market’s trend direction. It assigns the greatest weightage to the most recent price changes of the currency pair in the forex market. In our article, we discuss everything about the Exponential Moving Average.
What is Exponential Moving Average (EMA)?
An Exponential Moving Average is a type of moving average that places a higher weightage on the latest price levels and lesser weightage on the older price levels. Hence, it reacts more relevantly to price changes when compared with a Simple Moving Average. It helps in identifying buy and sell signals based on the EMA crossovers. An EMA line can be green or red when the prices are moving in an existing downtrend or uptrend, respectively, before reversing.
- A bullish crossover takes place when the red EMA crosses the green EMA from above and signals traders to place long or buy orders.
- A bearish crossover takes place when the red EMA crosses the green EMA from below and signals traders to place short or sell orders.
How to calculate Exponential Moving Average
1. Calculate the SMA
Calculate the Simple Moving Average of the specific time period to ascertain the initial (previous day) EMA value. Simple Moving Average = Sum of all closing prices/number of observations
2. Calculate the Multiplier
Calculate the smoothing multiplier or the weightage that is given to all prices. Smoothening = [2/(number of observations +1)]
3. Calculate the EMA
Calculate the current Exponential Moving Average by using the formula: Currency pair current closing price * multiplier + EMA (previous day) * (1-multiplier) Let us understand this with an example – Let us assume that you are trading USD/EUR with an EMA. You calculate a long-term EMA and short-term EMA with 50 and 20 trading periods, respectively. The current trading price level is 2, the two 50-day EMA’s value is 1.2, and the 20-day’s is 1.7. Since both EMAs are close to the current price level, it indicates a strong market trend and market continuation. Considering the currency pair prices have been increasing for a while, it is an existing uptrend. In this situation, when the 20-day EMA crosses the 50-day EMA from below, it generates a sell signal, and when it crosses the 50-day EMA from above, it generates a buy signal.
Exponential Moving Average vs Simple Moving Average
Exponential Moving Average and Simple Moving Average (SMA) are used to measure trends. SMA applies equal weightage to all price levels, whereas EMA applies higher weightage to the recent price levels. There are a few more differences between the two –
- EMA calculates the direction of the trend, whereas SMA only calculates the average price of the currency pair.
- To calculate a reliable level of EMA, you need to consider data points from at least ten days. However, you can calculate a reliable SMA with as low as a 4-day dataset.
- SMA is a smoother line that reacts slowly to price changes and is formed away from the price line. EMA, on the other hand, sticks closer to the price line as it reacts quickly to all changes.
- EMA is more sensitive to price changes than SMA because it provides different weightage to different prices.
- Traders can identify a trend faster with an EMA than with an SMA.
- Since EMA is quicker, it is preferred by day traders, and SMA is slower, it is preferred by long-term traders.
How to Use Exponential Moving Average in Your Trading
You can use the Exponential Moving Average in your trading by using two moving averages (long-term and short-term) together. The short-term EMA will reflect the current market movement, whereas the long-term EMA will reflect the overall broad trend of the market. When both trends align, it signals that the market trend is currently strong, and it is beneficial to open trades along the market trend. This means opening a long trade during uptrends and a short trend during downtrends due to the expected market continuation.
- A golden cross or bullish cross occurs when the short-term EMA crosses the long-term EMA from below and sends signals to long the trade.
- A death cross or bearish cross occurs when the short-term EMA crosses the long-term EMA from above and sends signals to short the trade.
You can also place buy orders based on the p[rice action. When the price dips are nearing, you can place a buy order right below the EMA line. On the other hand, you can place a sell order right above the EMA line when the prices are increasing continually.
Set up the EMA on your trading chart now
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