In the previous lesson, you learned that the Simple Moving Averages (SMA) indicator is integral in following market trends. However, SMA faces a major limitation – it’s not reactive to price changes.
Considering the inherently volatile nature of the forex market, this limitation hinders traders from fully exploiting the market.
Enter the Exponential Moving Averages (EMA) indicator – an improved moving average analysis. By putting more weight on recent price data, EMA adapts to price changes while providing a robust market perspective.
Exponential Moving Averages (EMA) addressed the primary limitation of Simple Moving Averages.
SMA simply factors in all the assets' closing prices for a specified period. While simple to implement, this approach overlooks one forex fact: price changes.
That makes SMA a little less reliable in a volatile market.
Read more: TradersUnited – The Basics of Simple Moving Averages (SMA)
To form a better interpretation of the market, traders use the Exponential Moving Averages (EMA) instead.
Unlike SMA, EMA prioritizes the most recent price data to be more adaptive to price changes. Weighting the last few price data creates a moving average line that better reflects the underlying price actions – whether it’s an outlier or not.
It’s more important to understand what traders are doing now rather than what they did over the past several weeks or months.
That’s the core of the Exponential Moving Averages (EMA)—they only concern themselves with the previous data points to emphasize what’s been happening to the market lately.
This approach makes EMA more dynamic and adaptable in the forex market.
Additionally, the common exponential moving average periods are 8-day and 20-day EMAs for the short-term. Otherwise, 50-day and 200-day EMAs are used for the long-term.
However, EMA indicates a similar signal to analysts—specifically, buy and sell signals based on MA crossovers and divergence.
Here are the two price actions that you’ll interpret through EMA:
Despite alleviating SMA’s restrictions, EMA is not foolproof by itself. All technical indicators, despite their reliability, are susceptible to providing false signals.
The primary limitation of EMA is its entire reliance on historical price data. Considering the efficiency of the market, it’s likely to reflect all available information. Thus, such historical data tells us nothing about the future price movement.
Like any technical indicator, EMA can provide false signals, potentially resulting in investment losses. This is because EMA overlooks an important aspect of the financial market—the fundamentals.
To address such limitations, an EMA trader should employ a multi-indicator analysis.
Calculating Exponential Moving Averages (EMA) is more complex than SMAs. Why? Simple – EMA calculation involves additional steps.
Here are the three primary steps you must take to calculate EMA:
Let us look at how trader Eli calculated USD/JPY’s 10-day EMA:
Trader Eli knew the profitable opportunity of the USD/JPY market.
Currently, the dollar-yen market has been trading in an extended uptrend for 10 days. With this observation, she decided to calculate the 10-day EMA of USD/JPY.
Following the three steps mentioned above, Eli started to compute the 10-day EMA of USD/JPY.
For the past 10 days, the USD/JPY market has been climbing.
To get the 10-day SMA, Eli sets her trading chart to candlestick view, adjusts the time frame to 24 hours (1 day), and starts jotting down the closing prices of the recent 10 candles/periods.
| Week One | 149.35, 151.20, 151.95, 152.44, 152.61 |
| Week Two | 153.57, 154.09, 153.49, 154.81, 156.55 |
After jotting down 10-day closing prices of the dollar-yen market, Eli can start calculating the 10-day SMA using the formula below:
SMA = (A1 + A2 + ... + An) / n
Where:
An = the asset price at a particular period (n)
n = the total number of periods
SMA = (149.35 + 151.20 + 151.95 + 152.44 + 152.61 + 153.57 + 154.09 + 153.49 + 154.81 + 156.55) / 10
SMA = 1530.06 / 10
SMA = 153.00
With this data, you can assume that the USD/JPY is trading at an average of 153.00 price point.
This will be your previous EMA for this calculation.
After getting the USD/JPY SMA, you can proceed in calculating the multiplier for weighting the EMA. This step is essential to smoothen the price fluctuations over the EMA period.
Weighted Multiplier = [2 / (period + 1)] x 100
Weighted Multiplier = [2 / (10 + 1)] x 100
Weighted Multiplier = [2 / 11] x 100
Weighted Multiplier = 0.1818 x 100
Weighted Multiplier = 18.18%
After getting the multiplier and the 10-day SMA, trader Eli must find today’s closing price.
Only then can she proceed to calculate the current Exponential Moving Average (EMA) following the PEMDAS mathematical rule.
Here’s the formula for EMA:
EMA = (closing price – previous day’s EMA) x multiplier + previous day’s EMA
EMA = (157.72 - 153.00) x 0.1818 or 18.18% + 153.00
EMA = 4.72 x 0.1818 + 153.00
EMA = 0.8580 + 153.00
EMA = 153.8580
After this calculation sequence, trader Eli concluded that the USD/JPY price is moving in an EMA of 153.85 price point.
She can then plot this into her trading chart and monitor how the EMA line performs in the current market movement.
Here are what she can do with her found EMA:
Exponential Moving Averages (EMAs) are popular for their sensitivity to recent price movements, making them effective for identifying trends in volatile markets:
For example, a 21-day EMA can provide quicker trend signals compared to a 50-day SMA, allowing traders to adjust their positions sooner.
EMAs often act as dynamic support or resistance levels, adapting to price changes more quickly than SMAs:
For instance, in strong trending markets, traders use a 50-day EMA to confirm support or resistance zones. Prices that repeatedly test and respect these EMAs reinforce their reliability.
Read more: TradersUnited – What Are Support and Resistance Levels in Forex?
EMAs are integral to crossover strategies, offering traders timely entry and exit signals:
These crossovers are especially popular in strategies like the MACD (Moving Average Convergence Divergence) indicator, where the interaction of EMAs generates actionable signals.
Because EMAs react quickly to price changes, they are favored by short-term traders:
For instance, combining a 9-EMA and a 21-EMA on a 15-minute chart can help identify rapid shifts in momentum.