Share:

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 of 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.

Calculating Exponential Moving Average 

EMA was formulated to overcome certain limitations of SMA. There are three steps involved in the calculation of EMA. These include the following –

  • Calculation of simple moving average.
  • Computation of multiplier.
  • Computation of current exponential moving average.

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 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.

Stock investing is now live on Groww

  • Zero fee

    on equity delivery

  • Low brokerage

    charges

  • Quick payments

    to keep up the pace

Therefore, according to the above example, the required multiplier will be 2/31= 0.06451, which is equal to 6.451%

Lastly, we require the following formula to calculate the current exponential moving average –

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.

Differences between SMA and EMA 

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 SMAEMA 
Reaction to fluctuation in price levelsSMA 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.
ObjectiveSMA 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 sentimentSMAs 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’ actionsSMA does not put weight on traders’ actions.EMA puts weight on the actions of the market participants.

Advantages of Exponential Moving Average

Some advantages of EMA are as follow –

  • Identifies and confirms the market trend 

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.

  • Act as support and resistance bands 

Similar to the other moving averages, EMA 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.

  • Sensitive to price movements 

An exponential moving average is considerably faster than SMA in reflecting rapid fluctuations in price levels of a financial instrument. Thus, EMAs are also able to identify trends faster than SMAs.

Drawbacks of Exponential Moving Average

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 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 simple moving average as it puts more emphasis on recent price points. All traders need to do is analyse each moving average method carefully before incorporating them in their trading practice.

Share: