What is EMA in Stock Trading? A Complete Guide

With the increased popularity in stock trading, a detailed understanding of several indicators is also necessary to level up the trading strategies and, in turn, the profit. Moving averages are one of the useful indicators that further divide into EMA and SMA.

Specifically, EMA is the most used indicator in technical analysis, but why? This article will discuss this in detail while evaluating what ema is in stocks and what it offers to stock traders. So let's quickly get to this bandwagon and learn what you so wanted to do.

What is the exponential moving average (ema)?

An exponential moving average is a type of moving average that places a greater weight and significance on the most recent price data causing it to react faster to price change. Traders use these moving average indicators to calculate the price movements of their shares throughout the time.

Exponential moving averages can be very profitable for traders who employ technical analysis. The EMA is preferred more by the traders due to its quickness. It gives more importance to the recent data points, which helps them in making trading decisions quickly.

The exponential moving average indicator shows an uptrend when the price moves upward and vice versa. Crossovers can also be easily identified by plotting one EMA with a shorter timeframe and another with a longer one.

The EMA is quite similar in functions to other moving averages. Specifically, it produces buying and selling signals based on crossovers and divergences from the historical average. However, the exponential moving average is considered more appropriate due to how they are calculated.

EMA is used in different lengths by traders according to their needs. For example, short-term traders rely more on 12-days EMA, whereas long-term investors rely more on 50-days or 100-days EMA. So, the time frame varies according to the trade needs.

If the moving average is taken over a longer period, the recent trading will be weighted less. This is because exponential moving averages are much better for trending markets like all rest of the moving averages.

Using EMA as a part of your trading strategy does not restrict you to using one specific instrument because using different instruments together enhances the quality and amount of your output in most cases.

How to calculate exponential moving average?

As you all know by now, the exponential moving average indicator is used to calculate the price movements of the trading securities. The stock traders calculate it by working on a simple formula to get accurate stock prices. The formula for calculating EMA is as follows:

K x (Current price – previous EMA) + Previous EMA.  

Here, k stands for the EMA's weighting factor. Its change in value depends on the period of the EMA's being calculated. For instance, you can calculate K for 21 days EMA by using the formula k= 2/ n+1, where n is the desired period of EMA, resulting in 0.095 or 9.52% weightage of EMA.

Moreover, if you are calculating EMA for the first time, note that your previous EMA is the initial EMA, usually the sum of all the closing prices over a specific period. Otherwise, the previous EMA is one that you have calculated from your last stock trading, or to say SMA.

 It is also very easy to calculate the initial EMA. For instance: if you want to calculate it for 20 days, you just have to divide the total sum of the stock market's closing prices of the last 20 days with 20. Following this, you have to calculate the weightage factor of EMA or a multiplier.

Calculating the EMA weightage value is also necessary because it smoothes or weighs the EMA of a selected period to help you decide more calculatedly. The last step is to work out the final formula for calculating EMA in stock trading. However, the EMA weightage value varies due to some factors.

One of these factors is that EMA value is greater when calculated by recent prices, unlike SMA, which gives equal values in all conditions. Therefore, it is a vital step to calculate EMA after some time to ensure profitable stock trading.

Exponential moving average (ema) and simple moving averages (SMA); What's the difference?

There are no such major differences between EMA and SMA as they are moving averages and are almost similar in measuring the trends to each other. But the SMAs are the most commonly used moving averages in the modern era.  

The primary difference between EMA and SMA is the sensitivity that both show to changes in data while doing calculations. For example, SMA calculates the average price data, while EMA gives more significance to recent data.

The EMA can react to the current market price more quickly as compared to SMA. It is one of the main differences between the two. However, one is not necessarily better than the other. SMAs are used to identify potential areas, whereas EMAs are used to identify potential changes.

The EMA shows an average of price action over a set period whereas, SMA doesn't show an average of price action over a set period. Both of the moving averages have different formulas than each other. Traders prefer EMA more for short-term trades, while SMA is preferred for long-term trades.

It was observed by the investors while analyzing the market that the EMA is better than SMA in a lower timeframe and is still considered best by the traders. This is because the speed of reaction to price changes of EMA ends up as more profitable for traders, rather than the slow reaction of SMA.

There is a high chance of getting caught up in fake-outs in EMA, while SMA would help you become prey to the fake-outs. However, the main difference is that EMA gives more weight to recent price data, whereas SMA assigns an equal weighting to all the values.

In short, moving averages on charts are often used to determine the trend or direction by the traders. Both these moving averages can be applied accordingly as both have almost equal strength. Traders apply both of the moving averages in different situations according to their requirements.

Exponential moving average example

Graphical representation of lines in the trading chart can be the proper application that helps you to identify a potential increase in the price of a 200-day EMA. When the price reaches that line during an upward trend on the chart, the EMA signals a support level, and the price increases again.

The selling signals for the 200-day EMA will be identified when the price touches that line from below, indicating that EMA is serving as resistance.

How does exponential moving average work?

The exponential moving average indicator isn't very difficult to set or use. Yet, you have to ensure that you have a defined trading strategy. The stock traders operate EMA as their own or combine it with another indicator to ensure accurate results.

It is preferably used for identifying price trends and buying and selling signals. So, the only difference in using two EMAs is that the traders can simultaneously locate trends of two timeframes. Above all, they can then also identify the cross-price movements in the stock market.

The traders can calculate EMA single-handedly by using the formula mentioned above and let it work to provide you with a general trading direction. It identifies price trends, offers support and resistance, and locates cross signals in stocks if it is set according to the desired trading strategy and time.

Advantages of exponential moving average

There are many advantages of using EMA in stocks. Some of them are given below:

1. The speed of reaction to price changes of EMA ends up as more profitable for traders.

2. EMA can be highly profitable for traders who can technically leverage ups and downs in a stock's price.

3. Exponential moving averages help us to judge the general direction. You can use EMA with any different instrument, which helps in enhancing the outcome.

4. The speed of EMA is just unmatchable, which makes it superior among all other moving averages.

5. It was observed that EMA is the most reliable moving average among all and reduces the noise of everyday price action.

6. The lagging capacity of EMAs is much better than the rest of the moving averages, which is one of the biggest advantages of using EMA.

7. EMA is preferable in a volatile market because it adapts quickly to price changes.

Disadvantages of Exponential moving average

Besides advantages, technology also comes with drawbacks, so using EMA in stocks also has some cons. The most prominent ones are as follows:

1. To read EMA calculations, one should know how to read EMA. It is because the calculations of EMA are more complicated to read than any other moving average.

2. EMA can be very dangerous if it is misinterpreted and does not tell you the exact top or bottom of a trade.

3. History maintenance and continually updating are required of different periods in the exponential moving average.

4. Often fails to recognize complex relationships revealed by data.

5. EMAs can not determine the optimal entry or exit as they are lagging indicators.

6. It does not support fluctuation problems that occur due to o seasonal impacts, etc.

7. There is a high chance of getting caught up in fake-outs in EMA. This is because they are only favorable for shorter time frames and do not support long time frames.

8. The exponential moving average is prone to more false signals than any other moving average.

How to read EMA for the following functions?

Price Patterns and trends

The traders use the exponential moving average indicator to locate the price patterns and identify the trends to maximize profit from trading stocks. The technical analyst also widely uses EMA to track price movements in the market.

The increase in EMA value indicates the upward trend, and the decrease in value shows that the prices are moving downwards. It also identifies price movements by locating its positions. This identification further helps the traders in identifying the ideal buying and selling points in stocks.

For example: if the price moves above the exponential moving average line, the price increases or undergoes an upward trend. However, if it is below the line, it moves downwards. Yet, it doesn't offer the traders guaranteed trading directions. It only provides the general idea of stock trading.

Identification of stock crossovers

The traders can use the exponential moving average indicator alone, or you can operate two EMA's of different time frames simultaneously to identify the overall movement of the market's securities. From different timeframes, we mean one with the shorter period and the other with the longer.

It helps the stock traders to identify selling and buying positions more accurately. If the EMA line following a shorter timeframe moves above the longer period line, it gives the golden or buying signal. If the longer one moves below, the shorter EMA line indicates the selling or death signal.

Support and Resistance

EMA offers support bands that prevent prices from falling below the line during trading. In addition, it limits the price movements by offering the support floor to stop it from falling below the expected line. It also offers resistance levels that prevent price movements from rising above the line during trading.

In other words, EMA defines the upward price trends and acts as a support barrier, where needed, to cease the price pattern before it intersects with the EMA line in the upward trend. In addition, EMA offers resistance to the downtrend price movements by limiting it from going above the expected level.

Limitations in EMA

The stock traders that have used the EMA indicator as a technical analysis imply that EMA gives more weightage if calculated for a shorter period. This is because they believe that the recent data shows accurate readings or can identify coming trends more accurately.

However, most stock traders also believe that calculating the weightage power of shorter EMA causes biased results or false readings as price trends keep changing with each passing day.

Moreover, the exponential moving average indicator only deals with the historic data for identifying price movements of the stocks. Yet, now the market structure reflects enough information that the traders may require to set their trading strategies, so it seems unnecessary.

FAQs

Does EMA work as standalone in stock trading?

An exponential moving average can be used alone too to identify price trends and patterns in stock trading. It can also provide accurate data regarding ideal buying and selling points by identifying price trends and adjusting them accordingly to ensure maximum profit.

What time frames work best with EMA in stocks?

Mostly the traders use the 50 to 200-day timeframes for setting the EMA for a longer period. However, traders set shorter period EMA's at 12 to 26 days. So, it depends on the trading strategies that the stock traders are utilizing. Moreover, these two EMA can also be used together.

Does EMA require modification for different securities or assets?

An indicator requires frequent modification as per the current trading strategy to ensure accuracy. Not all the securities or stocks fit in the same timeframe or follow the same pattern, so timely modification is necessary accordingly. It is suggested to set EMA for shorter timeframes.

Which timeframe is preferable for EMA in day stocks trading?

Usually, day traders use the EMA indicator for technically analyzing their asset's prices. As a result, they often calculate their EMA either 12 days or a maximum of 26 days. This timeframe is preferable as EMA shows greater weightage on the recent prices or shorter timeframes.

Is EMA beneficial for swing trading?

EMA is also used in swing trading. Most swing traders believe that calculating EMA of a longer time frame helps you identify the general trend of a security or a market. Mostly the 50 to 100 days EMA is used by long-term stock traders.

Bottom line

Both the types of moving average indicators work equally fine, yet their functions differ from each other. EMA is the most preferable over SMA as it is more efficient in identifying price movements and cross trends in the stock market.

Although the number of EMA and timeframe depends on the trader's strategies and the type of asset you want to trade in the market, it is preferable because it gives greater weightage power to the recently closed prices.

Conclusively, EMA doesn't lag much and works efficiently for almost both the day and swing traders. In addition, the EMA chart offers different lines for different indications that make it easy to read. So, apart from limitations and disadvantages, EMA is preferable in stocks.