The exponential moving average formula tells you the trend of a stock. Investopedia defines an exponential moving average (EMA) as a moving average similar to a simple moving average, except that more weight is given to the latest data. EMAs are great for intraday trading, swing trading, or investing.
They are also great for finding price reversals and determining whether the stock will be bullish or bearish. The slant of the EMAs shows if a stock is in an upward or downward trend. Knowing the stock trend will help determine if it is time to enter or exit a trade.
Be careful buying when the stock is indecisive because it can go either way. Always look for confirmation of the trade.
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Exponential Moving Average Formula (EMA) Introduction
Exponential moving average (EMA) lines are great on the 1-minute and 5-minute chart for day trading but can also be useful when swing trading. The 9 and 20 EMA’s are a great combination to help give trading signals for entries and exits. The 13 EMA can also be used; it can be used in conjunction with the 9 and 20.
If the 9 ema is over the 20, the price is bullish. If the 20 is over the 9, the price is bearish. When the 9 and 20 are close together, and it’s difficult to differentiate them, the stock is indecisive. Pay attention to ema crossovers, which signify potential reversal setups.
These indicators are added to your chart for information on trends, support, and resistance. The EMAs are used with other types of technical analysis to give you a better picture of what a stock has the potential to do.
EMA Calculation
The Exponential Moving Average (EMA) formula calculates the EMA. If you didn’t know, the EMA is a popular technical indicator used in stock analysis and trading. Since the EMA gives more weightage to recent price data, it’s sensitive to short-term price movements.
The formula to calculate the EMA is as follows:
EMA = (Close – EMA(previous day)) * (2 / (N + 1)) + EMA(previous day),
Where:
Close: The closing price of the current period.
EMA(previous day): The EMA value of the previous day.
N: The number of periods used to calculate the EMA.
To calculate the initial EMA value, you can use a simple moving average (SMA) as a starting point. Once you have the SMA, you can start calculating the EMA using the formula above.
It’s important to note that the EMA is a dynamic indicator that requires updating for each new period. The EMA recalculates as new data comes in to reflect the latest prices.
It’s worth mentioning that many trading platforms and charting software have built-in tools to calculate the EMA. So, there’s no need to panic; you don’t have to do the calculations manually.
This is an example of what exponential moving average lines look like in the ThinkorSwim platform. You’ll also see that I have simple moving average lines and vwap. This chart has the 9 ema, 20 ema, 50 sma, and 200 sma.
Day Trading
The exponential moving average formula is one of the best indicators for day trading. When day trading and seeing the price moving quickly, watching how it interacts with the 9 EMA can help gauge when to get in and out with a profit.
When in our trade room, members often hear someone saying, “to watch the 9 EMA.” Ideally, enter a trade when the price is as close to the 9 EMA as possible because the risk is low the closer you buy to the 9 EMA. Then you ride it up. If it breaks below the 9 EMA, you may want to consider an exit strategy. This is where the saying “ride the 9” comes from.
The 5 minutes can help with finding an exit as well. If the price is going between the 9 and 20 on the 1 minute but staying above the nine on the 5 minute, it’s still in a bullish trend. We always day trade with 1-minute and 5-minute charts open. VWAP is very complimentary to EMAs and a useful indicator.
Swing Trading
The exponential moving average formula is great for day trading but can also be useful when swing trading. Swing trading usually means holding a stock for 3-5 days. The EMA trading strategy on the daily chart can help determine whether to take the trade for that period.
The EMA crossovers play an important role in this, along with the RSI and MACD. If the EMAs are far away from each other daily and the RSI shows a stock is oversold, then being extra vigilant about what the EMAs are doing can be the best choice.
If the EMAs are moving in a direction that shows a crossover is coming, waiting to get in might be smart. Sometimes, they pinch but do not cross and then go back up. This could result in a loss if shorting or trading Puts.
Using the same EMA strategy as day trading to get in and out of a stock is also good for swing trading. Get into the trade when the price is as close to the 9 EMA. If the trading action is choppy, wait till the setup provides a good signal to enter.
Exponential Moving Average Formula Example
The chart above shows a simple bullish and bearish signal reversal using the 9 and 20 emas. The bullish crossover created a rising wedge pattern. It started as a bull flag breakout. The bearish crossover created a falling wedge pattern.
Candlesticks
EMAs will push the price up or down; watching them will tell whether it is time to enter or not and should wait. If the candlesticks are above the 9 and pushing up, try to stay in and follow your game plan. Sometimes, the best trade is no trade at all. Always wait for a setup that confirms the game plan.
If the candlesticks are breaking below the 9, watch what the 20ema decides to do. If it begins to cross and a candle sticks below it, it might be a sign to exit or short the stock and ride the pushdown.
Exponential Moving Average Formula Limitations
As you know, the Exponential Moving Average (EMA) formula is widely used in technical analysis for stock trading. However, it has limitations. Let’s examine a few of them below.
1. A Lagging Indicator
The EMA formula places more weight on recent data but still incorporates older data. Consequently, the EMA may not react quickly to sudden market changes or price reversals. Because it lags, it can disadvantage scalpers looking to profit from short-term price movements.
3. Sensitivity to Outliers
The EMA formula is sensitive to extreme price movements or outliers, which can significantly impact its calculation. This sensitivity can result in false signals or fluctuations in the EMA line, making it challenging to accurately interpret market trends
3. False Signals in Ranging Markets
EMA crossovers often identify trends or generate buy/sell signals. However, during periods of price consolidation or ranging markets, the EMA can produce frequent and contradictory crossovers, leading to unreliable signals.
4. Optimal Parameter Selection
Selecting the appropriate period (N) for the EMA calculation can be subjective. Different periods can produce varying results, and an unsuitable choice could lead to inaccurate signals or poor entries and exits.
5. Curve Fitting or Over-Optimization
Traders may be tempted to adjust the EMA parameters to perfectly fit historical data. Be aware that this approach, called curve fitting or over-optimization, can lead to unreliable results when applied to future market conditions.
It’s important to note that while the EMA formula has its limitations, it is still widely used in technical analysis. Traders often combine the EMA with other indicators and methods to improve their trading strategies and mitigate some of these potential issues.
To learn more about incorporating the EMA into your trading strategy, visit our website, where you can find a list of our courses!
Final Thoughts: Exponential Moving Average Formula (EMA)
The exponential moving average formula is a great technical indicator. Trading can be emotional, especially when seeing the profit moving up and down. These tools and following technical analysis give the trader a better chance of success.
Technical analysis keeps things in perspective, and the EMAs are a great way to see the trends quickly and make trading decisions. Trading without EMA’s or technical analysis is not trading; it is gambling.
Frequently Asked Questions
The formula for the moving average line depends on the specific period. It's calculated by adding up all the data points during the period and dividing it by the sum of the time periods.
The exponential moving average period (EMA) gives more weight to the recent price changes in a stock. The 9 EMA, 20 EMA, or the 13 EMA are the most popular EMA lines.
The EMA is used most effectively when the price rides above when bullish and below when it's bearish. Crossovers show potential short-term reversals.
The 5 EMA trading is a way to catch big short-term moves in a stock. It's used to calculate the 5-day exponential moving average line. It's a short term line indicator.
The exponential moving average gives more weight to recent prices in a stock. The simple moving average assigns an equal weight to pricing.
