Understanding Exponential Moving Average (EMA) for Trading

Broadly technical analysis is all about seeing the trend and predicting the future. Future is always uncertain and there is probability involved. I recommend using many indicators for a hawk eye view as it will provide the required congruence and high chance of success.

One such important indicator is Moving Average or Simple Moving Average. It is a simple yet very powerful indicator. It creates a summary in form of a line from the complex price data set of a historic range. It is calculated by taking a simple average of closing price points of the candlesticks. 

It is a lagging indicator and to make it more relevant technicians suggested giving more importance to most recent price candlesticks and lesser weight to past price candlesticks. This led to emergence of Exponential Moving Average or EMA. It's the sum average of price points multiplied by a weighing factor. The weighing factor can be considered having a constant value of 1 for all price points for calculating SMA but for EMA the values are such that the recent price points are given more weightage. The decrease between one price and its preceding price is not consistent and it decreases exponentially.

There is another acceptable form of MA, called the Weighted Moving Average (WMA). It's a modified form of EMA, with weighing decreases with each previous price. The weights are customized, the value of which is high for the most recent prices and decreases for the historical ones.

Moving average calculated for shorter period behaves more rapidly to price changes and is called a fast MA, conversely with larger periods is called slow MA.

Familiarizing the indicator on chart:

As Fibonacci range depicts natural events more closely I recommend to use EMA with following time periods:

n=8

n=13

n=21

n=55

n=200

After you activate these on the charts do remember to colour them with different colours for easy identification. I always use darker shades for higher n valued EMAs and lighter shade for lower n valued EMAs.

Identifying Crossovers

Moving averages highlight trends and are used to spot trend reversals. The trend line smoothens the noise of price action and shows the real direction of price movement. We use multiple EMA lines to predict the price movement, believe me it's really easy to spot the trend. When the lines cross each other cutting each other a cross over happens leading to price run in a specific direction.

Death Cross (or Downtrend):

When a fast EMA (eg: EMA 8) crosses a slow EMA (eg: EMA 200) sliding from top to bottom a death cross happens signaling the onset of a downtrend. The trader then must go for a short position.

Golden Cross (or Uptrend):

On a contrary when a fast EMA (eg: EMA 8) runs from bottom to top of a slow EMA (eg: EMA 200) signifies the beginning of price rise, the trader must go for a long position. 

Always colour code your EMAs for quicker spotting of crossovers. Use sharp and different colours so all EMAs are distinctly spotable. 

Mathematical Formula:

SMA = (P1+P2+..+Pn)/n

EMAt = Pt*EMult + EMAy*(1-EMult)

EMult = 2/(n+1)

For the period, first EMAy = SMA

WMA = [Pt*n + Py*(n - 1) + ...Pn*1]/ [n*(n+1)/2]

WMult = 2/(n+1)

where,

SMA = Simple Moving Average

EMA = Exponential Moving Average

EMAt= EMA for current candle (today)

EMAy=EMA for last candle (yesterday)

EMult = EMA Smoothing Multiplier

WMA= Weighted Moving Average

WMult = WMA Smoothing Multiplier

P = Closing price of the candle

Pt= P1 = Closing price of current candle (today)

Py= Closing price of last candle (yesterday)

Pn = Closing price of first candle in the selected period

n= no of past candles

Word of Caution:

Moving Average of any kind (SMA, EMA or WMA) is a lagging indicator relying on past data points and hence they suffer a time lag before they depict new trends. An immediate price spike would be captured only after it occurs.

Moving average with a shorter period suffers from less lag than one with a larger period. Moving Average with a short time frame will react much quicker to price changes than a Moving Average with a long look back period.

Technicians prefer to use EMA over WMA as the weighing factor exponentially gives more weightage to the recent price data, yielding much better predictions.

Trading Points:

Use EMA8, EMA13, EMA21, EMA55, EMA200. Colour code them for easy identification.

If the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down.

SMA is used mostly for finding supports & resistances