In case you wondered, moving averages are not just some colorful lines on your chart. They may actually be a great tool used in your trading strategy. Today, we will learn something new about one specific type of moving averages, which is called exponential moving average.
Simple MA vs Exponential MA
As you may know, there are four types of moving averages: simple, exponential, smoothed and linear weighted. The main difference between them lies in the sensitivity to changes in the data used in their calculation.
The exponential moving averages (EMA) provide a higher weighting to recent prices, while the simple moving average (SMA) gives equal weighting to all values. Since EMA gives a higher weighting to recent data than to older data, they are more reactive to the latest price changes than SMA. That is why some traders prefer this type of moving average.
The EMA’s calculation is a little bit more complicated than the calculation of the simple MA. At first, you need to calculate the simple moving average.
SMA = the sum of the closing prices for the number of time periods/the number of periods
Then you need to calculate the multiplier for smoothing/weighting factor for the previous EMA.
Multiplier= 2/(the number of periods+1)
Finally, you’ll get the exponential moving average for the current period.
EMA for the current period= (closing price- EMA for the previous period)*multiplier + EMA (previous period)
You may use SMA as the EMA for the previous period if you calculate the EMA for the first time.
Thanks to the era of technologies, we do not need to calculate the moving averages by ourselves. The computer does it for us. To apply the exponential moving average to your chart in Metatrader 4 you need to choose Insert – Indicators – Trend. Then you need to click on the button “Moving Average” and change the MA method to Exponential.
Trading with the EMA
There are different ways to use the EMA for trading. Let’s find out the most common strategy where the exponential moving averages may help you.
1. They can provide a buy/sell signal
The strategy listed below is perfect for scalpers.
A strategy to open a long position:
- Wait for the short EMA to cross the long EMA to the upside
- Wait for other confirmations (break of the key level)
- Place your stop loss upper or lower the consolidation zone below your entry point.
- Track the direction of the moving averages
- Close your position after the short EMA crosses the long EMA to the downside.
On the picture, we applied brown 13-period EMA and orange 21-period EMA to the 5-minute chart of AUD/USD on February 25. When the brown line crossed the orange line to the upside, the pair started to go up. For example, you entered a long position at 0.7162 with a stop loss at 0.7155. Then you waited for the brown EMA to cross the orange EMA upside down and closed your order at 0.7173.
Vice versa, if the brown line (short EMA) crosses the orange line (long EMA) to the downside, this may signal an opportunity to open a short position. You need to close your position when the short EMA crosses the long EMA to the upside.
On the same chart, the crossover of two EMAs on February 21 helped you to open a short position at 0.7097 with a stop loss at 0.7104. You waited for another cross and closed your position near the support at 0.7077 3 hours later.
2. It can be used as dynamic support and resistance
Sometimes the exponential moving averages may be used to set the support and resistance levels.
On the 5-minute chart of AUD/USD, we can see that the price can find the support and resistance around the 10-period EMA. The EMAs always move up or down depending on the price action. They may be helpful, but tricky as well. We highly recommend you to follow price action instead of blindly placing supports and resistances around these areas.
The main disadvantage of the exponential moving averages is that they increase the risks of fakeouts or irrelevant signals. That is why you need to take into account the current trend and price action before making any trading decision.
The Exponential moving average is a very useful indicator, which may help you to build your trading strategy, especially if you are a scalper. Clever implementation of the EMA will increase the opportunity to earn profits and to eliminate risks.