How to use the EMA in Trading

In case you wondered, Moving Averages are not just some colorful lines on your chart. They may be a great tool used in your trading strategy. Today, we will learn something new about one specific Moving Average type, called Exponential Moving Average (EMA).

What Is Exponential Moving Average (EMA) in Trading?

As you may know, there are four types of Moving Averages: simple, exponential, smoothed, and linear weighted. Their main difference 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 more weight 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. 

Simple MA vs Exponential MA

The Exponential Moving Average (EMA) and the Simple Moving Average (SMA) are both technical indicators that use past data to generate a smooth trend line for the security price. The difference between the two Moving Averages is that EMA places a greater weight on recent prices, whereas SMA places equal weight on all data points, which is why the EMA line turns faster than the SMA line.

The optimal Moving Average to use for analysis depends on the trading strategy. However, it is important to note that none of the Moving Averages is better than others. For example, although an EMA is a more accurate representation of recent price movements and helps identify trends quicker, it also experiences more short-term fluctuations than an SMA.

How to Calculate Exponential Moving Average (EMA)?

The EMA’s calculation is a little 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 the 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 ourselves. The computer does it for us.

How to Set Up EMA?

To apply the Exponential Moving Average to your chart in both MetaTrader 4 and MetaTrader 5, you need to choose Insert – Indicators – Trend. Then you need to click on the “Moving Average” button and change the MA method to Exponential.

You can also choose the period, method, and even the color of the EMA.

Experienced traders usually calculate EMA according to the close price.

The 8- and the 20-day EMA tend to be the most popular periods for day traders, while the 50 and the 200-day EMA are better suited for long-term investors.

Trading with the EMA

EMA Ribbons Strategy

Traders sometimes watch Moving Average Ribbons, which plot many Moving Averages onto a price chart rather than just one moving average. Though seemingly complex-based, EMA ribbons are easy to see on charting applications and offer a simple way of visualizing the dynamic relationship between trends in the short, intermediate, and long term.

Traders and analysts rely on Moving Averages and Ribbons to identify turning points, continuations, and overbought/oversold conditions, define support and resistance areas, and measure price trend strengths.

To construct a moving average ribbon, plot many Moving Averages of varying time period lengths on a price chart. Common parameters include eight or more moving averages and intervals that range from a 2 to 400-period moving average. The most popular EMA ribbon consists of eight lines from the 20 to 55-period EMAs.

When all the Moving Averages converge into one point on the chart, the trend strength is possibly weakening and pointing to a reversal. The opposite is true if the Moving Averages are fanning and moving apart, suggesting that prices range and that a trend is strong or strengthening.

In downtrends, shorter Moving Averages cross below longer Moving Averages. In uptrends, conversely, show shorter Moving Averages cross above longer Moving Averages.

Moving Average Ribbons are easy to interpret. The indicators trigger buy and sell signals whenever the Moving Average lines all cross at one point. Traders look to buy when shorter-term Moving Averages cross above the longer-term Moving Averages from below and sell when shorter Moving Averages cross all other lines from above.

Moreover, traders use EMA Ribbon as support and resistance level:

• If during an uptrend the price breaks and closes the candle below the EMA Ribbon, it’s a sell signal.
• Vice versa, if during a downtrend the price breaks and closes the candle above the EMA ribbon, it’s a buy signal.

Important: For ease of analysis, keep the type of Moving Average consistent across the Ribbon. Use only Exponential Moving Averages or Simple Moving Averages.

Two EMAs strategy

The strategy listed below is perfect for swing traders. We suggest you use the H1 timeframe as it fits the strategy the best since using two EMAs on lower timeframes might create lots of interrupting noise.

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 behind the last high or low.
• Track the direction of the Moving Averages.
• Close your position after the short EMA crosses the long EMA to the downside or the price reaches your target. 

In the picture, we applied brown 13-period EMA and orange 21-period EMA to the H1 chart of AUDUSD on Jun 15. The pair started to go up when the orange line crossed the brown line to the upside. A trader enters the long position after the breakout of the recent high, which acts as a resistance level. Then he/she closes the position as the orange EMA crosses the brown one upside down.

Vice versa, if the orange line (short EMA) crosses the brown line (long EMA) to the downside, this may signal an opportunity to open a sell trade. You need to close your position when the short EMA crosses the long EMA to the upside.

EMA can be used as dynamic support and resistance

Moving Averages can also indicate support and resistance areas. A rising EMA tends to support the price action, while a falling EMA tends to provide resistance to price action. A trader should open a buy trade when the price is near the rising EMA and sell when the price is near the falling EMA. For this strategy, 25 EMA on H1 fits the best.

Conclusion

The preferred number and type of Moving Averages can vary considerably between traders, based on investment strategies and the underlying security or index. But EMAs are especially popular because they give more weight to recent prices, lagging less than other averages. There are many great strategies include the EMA, and EMA Ribbon is one of the most useful tool traders use to find an entry point and stop the market reversal.

Author: FBS Analyst Team

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