The Simple Moving Average (SMA) is undoubtedly most popular among its siblings but its Exponential Moving Average (EMA) cousin also has a solid fan base. It’s actually quite similar to the SMA with the one difference being that more weight is given to prices that are more recent. The idea behind this is that it should react to newer price movements better than the SMA and “catch” the effect of what has been happening recently, rather than equaling it to past periods.
For longer term investors the 50- and 200-day Exponential Moving Average are among the most popular, while the 12- and 26-day EMAs are used by day traders.
Let’s use a 10-day EMA as an example for its calculation. The first step is to calculate the SMA for that period, as there needs to be a starting period for the EMA to establish an average from. The next step is to find the weighting multiplier and third is finding the EMA for every day between the initial value and today. Here is the formula itself:
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).
From all this we can see that the last period has an 18.18% weight in the calculation of the exponential moving average, far greater than the 10% it would have if this was an SMA.
Thankfully, this whole calculation is automatic in all platforms, so there’s no need to remember all the details. But the important point to keep in mind is that the shorter the period, the more weight is given to recent prices, and vice versa.
Another point to remember is that a short time period generates a line quite closely following the actual candles on the chart. Visually this means that there are more occurrences of the price moving above or below the EMA – something some traders interpret as a signal to open or close a position. This is one of the reasons why it’s preferred by day traders, while long term traders are known to prefer the SMA.
Still, the EMA is a lagging indicator and just like the SMA – it works best in trends. But because it’s more sensitive to the latest developments of the price – and especially if sharper moves have happened recently – traders use it to find the optimal entry positions right after a support or resistance has been broken, or when a psychological level has been breached.
