What is Exponential Moving Average (EMA)?

The Exponential Moving Average (EMA) is a very common technical indicator that calculate the average of consecutive days prices but places more weight on recent prices/ recent data points (unlike simple moving average which places an equal weight on all data points). The exponential moving average of stock price usually takes the closing prices and like SMA, it smooths out price action of an asset.

How do you calculate Exponential Moving Average (EMA)?

The exponential moving average formula is as follows:

EMA Today = (Value Today x (Smoothing/ 1 + Days)) + (EMA Yesterday x (1 - (Smoothing/ 1 + Days))

The value of smoothing is usually set to 2 (this is the figure used on Composer). The term (Smoothing/ 1 + Days) is often referred to as the multiplier and short term EMAs put more weight on the most recent price / time period than longer-term EMAs. For example, the multiplier for a 10-day EMA is (2/1+10) = 2/11 whereas the multiplier for a 5-day EMA is (2/1+5) = 1/3.

As you can also see, EMA is recursive in that it uses the previous day’s EMA in the calculation (just like relative strength index RSI). Currently on Composer, we use up to 1000-day look-back window to minimize error.

How do you interpret Exponential Moving Average (EMA)?

All moving averages including SMA and EMA are lagging indicators. The number of periods used determines the style of EMA (short term vs long term) you want to use. The most common short-term EMAs used are 12-day EMA and 26-day EMA. Longer term EMAs include 50-day EMA and 200-day EMA. When the stock price goes above the 200-day EMA indicator, one technical signal is that this could be a reversal.

EMA is much better suited to trending markets - when there’s a strong upward trend, the EMA line will also show an upward trend. Likewise for a downward price change, the EMA line will also show a downward trend. Looking at the rate of change of the EMA line can also be a useful indicator to signal a potential reversal or change in strategy.

How can you use Exponential Moving Average (EMA) in a stock trading strategy?

EMA is used in technical analysis in a variety of ways.

Like the SMA crossover strategy, one popular strategy is the EMA crossover (moving average crossover) strategy. To do this, you may look at a short-term EMA and compare it with a long-term trend EMA. For example, if the short-term EMA is greater than the long-term EMA, this can indicate an uptrend and a buy signal. This is known as a golden cross. On the other hand, if the short-term EMA is less than the long-term EMA, it can indicate a downtrend and a sell signal. This is known as a death cross.

Composer is a stock trading platform with a community of over 1,000+ user-built strategies on their Discover page. Here's some examples of user-built stock trading strategies that use EMA.

• This strategy “D0pp || V1 200D EMA QQQ Test Sector Rotation MA/RSI” (link) compares the current price of QQQ to the 200d EMA of QQQ. If this condition is true, the strategy invests in the bottom 3 sectors of a basket based on RSI (aka oversold). Otherwise it rotates across a variety of sector ETFs based on the 200d cumulative return.

• Likewise, this strategy “Total Market Hedged V 1.1” (link) compares the 200d EMA of SPY to the current price of SPY to go into a bull-market focus.

What are the limitations of Exponential Moving Average (EMA)

EMA uses historical data and as the saying goes, past performance is not an indicator of future performance (EMA is a lagging indicator). If you believe that markets are efficient, then the current market price already reflects all available information and hence EMA doesn’t tell you anything more.

In addition, EMA weights the most recent data more and there is debate on whether this can cause bias.

What are similar indicators to Exponential Moving Average (EMA)?

Another technical indicator similar to EMA is the Simple Moving Average (SMA). While SMA places an equal weight on all time periods, the EMA places more weight on more recent time periods. The EMA is an example of a weighted moving average.

Another moving average technical indicator is the Moving Average Convergence Divergence (MACD). This shows the relationship between two EMA of a securities price.

Sources

• https://www.investopedia.com/terms/e/ema.asp

• https://www.investopedia.com/terms/s/sma.asp

• https://www.investopedia.com/articles/active-trading/052014/how-use-moving-average-buy-stocks.asp