Some traders use exponential moving averages (EMAs) in an effort to try to meet their investment objectives. By harnessing these particular averages, investors attempt to evaluate a security's price history, placing special emphasis on the most recent fluctuations in value.
What Are Moving Averages?
EMAs are a type of moving average, a technical indicator some investors use to analyse a security's price history. Remember, past performance is not indicative of future results. Moving averages are lagging indicators, meaning they track past data. Some traders use them to produce transaction signals or to try to confirm the strength of a given trend.
Moving averages measure a security's mean value over a period of time, smoothing out the random price fluctuations. Some traders find them particularly helpful because of this aspect.
By focusing on an investment's average price during a specific period, instead of monitoring its every fluctuation in value, some believe they can more easily identify the security's trend. This refers to whether the trend is moving higher or lower along with key support and resistance.
In addition, traders can use moving averages to develop more complex technical indicators and overlays such as the moving average convergence divergence and Bollinger Bands.
What Are Exponential Moving Averages?
EMAs (also known as exponentially weighted moving averages) are slightly different from other kinds of moving averages, such as simple moving averages (SMAs), in that they do more to account for the latest price fluctuations. The idea behind using EMAs is that the most recent movements may be more useful in helping investors accurately predict what will happen in the near future.
Calculating The EMA
To calculate the EMA, investors should first determine the SMA. For example, calculating a security's SMA over the last 15 days would simply involve taking the last 15 closing prices and then dividing that figure by 15.
The next step involves figuring out which multiplier the trader wants to use in order to provide the most recent data points with greater significance. The EMA's length will play an important role in the multiplier size, with a shorter EMA coinciding with a larger multiplier and a longer EMA having a smaller multiplier.
Investors can use the following formula to calculate the multiplier:
Multiplier = (2/[number of time periods] + 1)
- Determining a 10-day EMA: (2/[10 + 1]) = 0.1818 or 18.18%
- Determining a 20-day EMA: (2/[20 + 1]) = 0.0952 or 9.52%
- Determining a 30-day EMA: (2/[30 + 1]) = 0.0645 or 6.45%
- Determining a 40-day EMA: (2/[40 + 1]) = 0.0488 or 4.88%
After obtaining the multiplier, you can use the following equation to determine the EMA:
- Multiplier x (closing price – EMA[previous day]) + EMA(previous day)
Investors can potentially use EMAs to analyse securities in either the short-term or long-term. To evaluate a security over a brief period, some traders use EMAs with lengths such as 12 days or 26 days. When analysing a longer time frame, investors may turn to 50-day and 200-day EMAs.
While short-term moving averages track prices closely, they can change rather quickly. In contrast, longer moving averages may not follow prices as closely, and they also take more time to alter their course.
Some investors harness rising moving averages to identify uptrends and falling moving averages to signal downtrends. The length of these moving average being assessed can also provide helpful information, as a short-term moving average points to a brief trend and a long-term moving average reflects a more prolonged trend.
Traders might use bullish crossovers, which involve short-term moving averages surpassing long-term moving averages, to confirm upward momentum. In contrast, some investors turn to bearish crossovers, which take place when short-term moving averages fall below long-term moving averages, to confirm downward momentum.
Support And Resistance
Some investors use EMAs to identify support—a price point that a security will likely not fall below because of supportive buying—in addition to resistance—a price the same security will probably not surpass seeing as how approaching that value will likely trigger sell-offs.
However, other traders prefer to use SMAs when identifying support and resistance, as an SMA is a true average of a security's price history over a certain time. Also, some would opt to use this type of moving average in discovering support and resistance, because an EMA will change more quickly than an SMA due to its greater emphasis on recent price data.
When considering different strategies, investors may benefit from keeping in mind that while moving averages can be very helpful in uncovering trends, securities frequently trade within ranges, a situation that can render moving averages ineffective.
Additionally, moving averages provide late signals because they are lagging indicators, which could make it more difficult for traders to buy low and sell high.
Investors should keep in mind that while moving averages can certainly be helpful, some traders will not use them by themselves and will instead insist on combining them with other tools. As always, risk is inherent to investment. Investors interested in strategies such a EMAs should be sure to research them in-depth and consult an independent financial adviser before entering any positions.
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