Exponential Moving Average (EMA)
EMA is a type of moving average that places a greater weight and significance on the most recent data points. It is also referred to as the exponentially weighted moving average. Exponentially weighted moving averages react more significantly to recent price changes than a simple moving average, which applies an equal weight to all observations in the period.
The 12- and 26-day exponential moving averages are often the most popularly quoted or analyzed short-term averages. The 12- and 26-fay are used to create indicators like the moving average convergence divergence (MACD) and the percentage price oscillator (PPO). In general, the 50- and 200-day EMAs are used as signals of long-term trends. Very often, by the time a moving average indicator line has made a change to reflect a significant move in the market, the optimal point of market entry has already passed.
Exponential moving averages (EMAs) reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average. There are three steps to calculating an exponential moving average (EMA). First, calculate the simple moving average for the initial EMA value. An exponential moving average (EMA) has to start somewhere, so a simple moving average is used as the previous period’s EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the exponential moving average for each day between the initial EMA value and today, using the price, the multiplier, and the previous period’s EMA value. The formula below is for a 10-day EMA.
Initial SMA: 10-period sum / 10
Multiplier: (2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)
EMA: {Close – EMA(previous day)} x multiplier + EMA(previous day).
The longer the moving average, the more the lag. A 10-day exponential moving average will hug prices quite closely and turn shortly after prices turn. Short moving averages are like speedboats – nimble and quick to change. In contrast, a 100-day moving average contains lots of past data that slows it down. Longer moving averages are like ocean tankers – lethargic and slow to change. It takes a larger and longer price movement for a 100-day moving average to change course.
Trend Identification
The direction of the moving average conveys important information about prices. A rising moving average shows that prices are generally increasing. A falling moving average indicates that prices, on average, are falling. A rising long-term moving average reflects a long-term uptrend. A falling long-term moving average reflects a long-term downtrend.
Double Crossovers
Two moving averages can be used together to generate crossover signals. Double crossovers involve one relatively short moving average and one relatively long moving average. A bullish crossover occurs when the shorter moving average crosses above the longer moving average. This is also known as a golden cross. A bearish crossover occurs when the shorter moving average crosses below the longer moving average. This is known as a dead cross. These signals work great when a good trend takes hold. However, a moving average crossover system will produce lots of whipsaws in the absence of a strong trend.
The chart below shows 10-day EMA (green dotted line) and 50-day EMA (red line). The black line is the daily close. Using a moving average crossover would have resulted in three whipsaws before catching a good trade. The 10-day EMA broke below the 50-day EMA in late October (1), but this did not last long as the 10-day moved back above in mid-November (2). This cross lasted longer, but the next bearish crossover in January (3) occurred near late November price levels, resulting in another whipsaw. This bearish cross did not last long as the 10-day EMA moved back above the 50-day a few days later (4). After three bad signals, the fourth signal foreshadowed a strong move as the stock advanced over 20%.
Support and Resistance
Moving averages can also act as support in an uptrend and resistance in a downtrend. A short-term uptrend might find support near the 20-day simple moving average. A long-term uptrend might find support near the 200-day simple moving average, which is the most popular long-term moving average. In fact, the 200-day moving average may offer support or resistance simply because it is so widely used. The chart below shows 200-day simple moving average from mid-2004 until the end of 2008. The 200-day provided support numerous times during the advance. Once the trend reversed with a double top support break, the 200-day moving average acted as resistance around 9500.
