Exponential Moving Average (EMA full form in stock market) is a kind of moving average that places a greater weight and importance on the most current data points. It is used for evaluating the bullish and bearish trends in securities over a certain span of duration.
Let's understand its meaning, formula, and more detail here.
An exponential moving average (EMA) is a widely used technical chart indicator that tracks changes in the price of a financial instrument over a certain period. Unlike simple moving average (SMA), EMA puts more emphasis on recent data points like the latest prices. Hence, the latter responds to a change in price points faster than the former.
The primary objective of all moving averages is to identify trends of a financial instrument based on its previous price points. They are, thus, referred to as lagging indicators.
Moving averages cannot predict any change in future prices; they can only confirm if there have been any changes in a stock’s trends.
EMA was formulated to overcome certain limitations of SMA. There are 3 steps involved in the calculation of EMA. These include the following–
The first step involves calculation of SMA, which is a fairly straightforward process.
To undertake this calculation, the sum of all closing prices of a stock during a specific timeframe has to be divided by the total number of observations in that given period. For example, in the case of a 30-day SMA, the sum of the closing prices of the last 30 trading days has to be divided by 30 (number of observations).
The second step involves the computation of the multiplier. The required formula for the same is given below –
{2/ (total number of observations + 1)}
Here, the total number of observations is 30.
Therefore, according to the above example, the required multiplier will be 2/31= 0.06451, which is equal to 6.451%
So, how to calculate Exponential Moving Average? We require the following formula for the same:
EMA = [Closing Price of the Stock x the Multiplier] + [Previous Day EMA x (1- the Multiplier)] |
Due to this distinctive calculation procedure, EMAs are able to track the prices of a financial instrument more closely than their corresponding SMAs.
Now that we’ve discussed what is exponential moving average, it’s essential for traders to learn some key differences between SMA and EMA.
Basis of Comparison | SMA | EMA |
Reaction to Fluctuation in Price Levels | SMA is not fast enough to respond to rapid price fluctuations. | The calculation process of EMA makes it respond faster to rapid changes in price points. |
Objective | SMA is used when a trader is holding a certain position (long or short) for a long period of time. These calculations are also used to filter out noise arising due to random price movements to identify the market trend. | EMA is used for shorter time periods and fast-moving markets. |
Representation of a Shift in Market Sentiment | SMAs are not capable of representing a quick shift in market sentiment. | EMAs are capable of representing a quick shift in market sentiment. |
Weight on Traders’ Actions | SMA does not put weight on traders’ actions. | EMA puts weight on the actions of the market participants. |
Some advantages of EMA are as follows –
This is one of the fundamental functions of EMA. When an EMA line is going in an upward direction, it denotes an uptrend, whereas when it goes down, it indicates a downtrend.
Usually, if the EMA line is above the price of the asset, it is likely to fall next. But, if the price level is above the EMA line, it is an indicator that the value of an asset will continue to increase. Hence, traders are able to identify the buy and sell signals with the EMA working as a chart indicator.
Similar to the other moving averages, exponential moving average also acts as resistance and support bands for the prices of a financial instrument. Also referred to as floors, support levels are predetermined prices of financial instruments beyond which they cannot fall.
Conversely, a resistance level is a predetermined price limit of a financial instrument beyond which its price cannot rise. Resistance levels are also referred to as ceilings.
An EMA is considerably faster than an SMA in reflecting rapid fluctuations in the price levels of a financial instrument. Thus, EMAs are also able to identify trends faster than SMAs.
Although EMA brings the above-mentioned advantages to the plate, they are not free from certain limitations.
As discussed previously, EMA puts more weight on the most recent data points. Many market participants believe that this offers a better reflection of the current trend of a financial instrument. But there are other traders who suspect that putting excess emphasis on the latest data points can bring about more false alarms.
Also, many economists think that financial markets are efficient. This suggests that the current market prices of financial instruments represent all necessary information. Consequently, any historical data is considered to be of no use in determining the future value of a financial instrument.
The choice of moving average method depends solely on the investment strategies formulated by traders. But usually, the exponential moving average method gets more preference over the simple moving average as it puts more emphasis on recent price points. All traders need to do is analyze each moving average method carefully before incorporating them into their trading practice.