As a Forex Trader or an aspiring Forex Trader, you must have heard the word “EMA” before; either from the indicator tab on your trading platform or from forex books or articles. In today’s article, we will explain what EMA means and how it can be used effectively in trading Forex, if only you will read down to the last word on this article.
EMA is an acronym for Exponential Moving Average similar to SMA, which mean Simple Moving Average except that the formal is exponential and the latter is simple. What is the difference between both, you may ask? We will examine those later. But before we proceed, let us first explain what is Moving Average.
What are Moving Averages?
Moving Averages (MA) is just similar to the normal arithmetic average we know of in mathematics. In terms of finance, especially in the Foreign Exchange Market. They are used as technical indicators to identify trends, supports and resistances and are most times used as a confirmatory indicator to filter false signals.
Moving Average (MA) are of different types example include:
- Simple Moving Average (SMA)
- Exponential Moving A verage (EMA)
- Smoothed Moving Average (SMMA)
- Linear Weight Moving Average (LWMA)
Each type of Moving Average (MA) has it specific use and function, unfortunately we cannot go into much details on all the types of Moving Average, expect the Exponential Moving Average, which is our main case of study.
The two most used Moving Averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA)
What is Exponential Moving Average (EMA)?
The EMA is an indicator that defines the current direction of a currency, stock, commodity etc. the Exponential Moving Average reduces the latency by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the Exponential Moving Average.
Now, let us look at how the EMA is calculated.
The reason why the Exponential Moving Average (EMA) is used more than other Moving Average is that the EMA gives a better support and resistance and offer a great price direction, which is because when calculating for the EMA we apply more weight to the recent prices thus reducing the latency.
When calculating for the Exponential Moving Average ( EMA) we first get the Simple Moving Average (SMA), next, calculate the weighting multiplier and finally, calculate the exponential moving average for each day.
The example below is a 21 days EMA
Simple Moving Average (SMA): 21 period / 21
Multiplier: (2 / (Time periods + 1) ) = (2 / (21 + 1) ) = 0.09090(9.09%)
EMA: (Close – EMA(previous day)) x multiplier + EMA(previous day).
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The Difference Between Exponential And Simple Moving Average.
Though there are some differences between the SMA and EMA , that doesn’t mean that the Simple Moving Average is better than the Exponential Moving Average. Each moving Average is used for a specific purpose take for example a trader might decide to use the Simple Moving Average with a MACD indicator to be sure of a trend direction while another trader might use the parabolic SARS indicator with an EMA to be able to know the swing point.
One of the differences between the SMA and EMA is the mode of calculation; the SMA uses a little data while the EMA uses more data.
EMA gives a higher weighting to recent prices, while the simple moving average (SMA) assigns equal weighting to all values- that is to simply say that EMA react more to price changes than SMA.
The Best EMA Period to Use?
This is very confusing question that many traders do ask, but unfortunately there is NO HOLY GRAIL to make one successful.
The period to use depends on the trader, is he a scalper? Intraday or Position Trader all this are the first question we need to ask.
For position trader, that hold there possible for more than a month might need to use either 100, 150 or 200 period EMA. The reason is because, position traders will want to make sure a potential reversal will last for months so they need to be certain that it is not a fake trade signal or fake break out
For other traders such as scalpers and day trader, they might decide to use 10 – 21 period EMA as this will help to show short-term trend as well as support and resistance if used properly.
Swing traders can use the same 21 period if they wish to or 50 periods for a better confirmatory signal.
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NOTE: it is best to use the EMA with another indicator such as parabolic SARS or MACD, which show trend direction. You can also use multiple period of EMA as a cross over confirmatory signal for example a swing trader might use 18, 25 and 50 period to examine how strong trends are and the possible duration of the trend.
In summary, the EMA is usually the first among the Moving Average to adjust to price change and as such, it is sometimes prone to fake breakout or false trend but if properly used well with another indicator can be a powerful tool.
One of the factors affecting the EMA is the period, an Exponential Moving Average with 10 period will react fast to price changes while an Exponential Moving Average with 50 period will be slow to react to very price changes, this is because it has more historical price data to calculate.