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Last Updated : Sep 22, 2018 10:25 AM IST | Source: Moneycontrol.com

Technical Classroom: Key tips to use Exponential Moving Average for profitable trading

An exponential moving average is a moving average for time-series data which places greater weight on more recent data. It is also called as price-weighted moving average for the price of a stock or an index for a given period of time.

Moneycontrol Contributor @moneycontrolcom

Shabbir Kayyumi

Narnolia Financial Advisors

Basics of Technical Analysis: Part 8

An exponential moving average is a moving average for time-series data which places greater weight on more recent data. It is also called as price-weighted moving average for the price of a stock or an index for a given period of time. An EMA differs from a simple moving average in that it attaches more significance to recent data, making it more sensitive to early indications of a change to the current trend. This makes EMA a very powerful technical tool for intraday and other short term trading.

Calculations of Exponential Moving Average

One should notice how the EMA uses the previous value of the EMA in its calculation. This means the EMA includes all the price data within its current value. The newest price data has the most impact on the Moving Average and the oldest prices data has only a minimal impact.

Image122-09-2018

The smoothing constant K, applies appropriate weight to the most recent price. It uses the number of periods specified in the moving average.

The exponential moving average (EMA) is a weighted average of the last n prices, where the weighting decreases exponentially with each previous price/period. In other words, the formula gives recent prices more weight than past prices.

• Exponential Moving Average (EMA) = ( 2 / n+1) * [Close - previous EMA] + previous EMA

Example: Calculation of 5 periods EMA of Nifty


One can find details calculations with illustration of Nifty EMA, where by Close price, SMA and EMA of Nifty are mentioned to get clarity of EMA calculations.

Image222092018Figure 1. Nifty 5 Day EMA calculations table


If a trader wishes to see a 20-day average instead, the same type of calculation would be made, but it would include the prices over the past 20 days.

Common Uses of the EMA
•> Generating a Buy Signal
•> Generating a Sell Signal while Trading
•> Exponential Moving Average provides Dynamic Support and Resistance

•> Intraday trading strategies

Major Types of Moving Averages

Moving averages visualize the average price of a financial instrument over a specified period of time. However, there are a few different types of moving averages. They typically differ in the way that different data points are weighted or given significance. The most popular Major types of moving averages are mentioned below.

•> SMA (Simple Moving Average)

The simple moving average (SMA) calculates an average of the last n prices, where n represents the number of periods for which you want the average:

Simple moving average = (P1 + P2 + P3 + P4 + ... + Pn) / n

•> EMA (Exponential Moving Average)

The exponential moving average (EMA) is a weighted average of the last n prices, where the weighting decreases exponentially with each previous price/period. In other words, the formula gives recent prices more weight than past prices.

Exponential moving average = [Close - previous EMA] * (2 / n+1) + previous EMA

•> WMA ( Weighted Moving Average)

The weighted moving average (WMA) gives you a weighted average of the last n prices, where the weighting decreases with each previous price.

Image322092018
Figure2. Nifty 21 Day WMA/EMA /SMA


This works similarly to the EMA, but you calculate the WMA differently. It has different weights assigned based on the number periods used in the calculation.

Weighted moving average calculation = (Price * weighting factor) + (Price previous period * weighting factor-1)...

Differences between EMA & Simple Moving Average

If you look at a chart with a simple moving average (SMA) and an exponential moving average, you won’t be able to differentiate between the two at first glance. However, under the hood, there are key differences in terms of how they are calculated.

•> The EMA adapts more quickly to price changes than the SMA.

For example, when a price reverses direction, the EMA will reverse direction quicker than the SMA. This takes place because the EMA formula gives more weight to recent prices, and less weight to prices that occurred in the past.

•> The SMA and EMA are calculated differently.

And it is the calculation that makes the EMA quicker to react to price changes and the SMA react slower. That is the main difference between the two. One is not necessarily better than another, though.

•> Sometimes the EMA will react quickly, causing a trader to get out of a trade on a market hiccup, while the slower-moving SMA keeps the person in the trade, resulting in a bigger profit after the hiccup is finished.

•> Moving averages are the basis of chart and time series analysis. Simple moving averages and the more complex exponential moving averages help visualize the trend by smoothing out price movements. One type of MA isn't necessarily better than another, but depending on how a trader trades, one may be better for that particular individual.

Intraday Trading Strategy with EMA

We would like to share one of the popular trading strategies among intraday trader fraternity. All trades should be followed with strict rules of entry, exit. Whenever we follow some system it is mandatory to follow strict stop loss as trading discipline.

Setup

•> 3 EMA (8/13/21) & Stochastic Oscillator on any timeframe, preferably 5 min.

Buy Signal

•> Entry– Whenever 3 EMA bullish crossover occurs (shorter EMA crosses 2 Larger EMA) and stochastic is crossing 50 (center line) from below around same time.

•> Exit-1)Bearish crossover of 3 EMA or 2)Stochastic crossing 50 from above or 3)SL-Low of previous candle is triggered.

Sell Signal

•> Entry– Whenever 3EMA bearish crossover occurs (shorter EMA crosses 2 Larger EMA) and stochastic is crossing 50 (center line) from above around same time.
•> Exit-1)Bullish crossover of 3 EMA or 2)Stochastic crossing 50 from below or 3)SL-High of previous candle is triggered.

Image422092018
Figure3. EMA intraday trading strategy illustration


Conclusion
•> An exponential moving average is a moving average for time-series data which places greater weight on more recent data.
•> An Exponential Moving Average (EMA) is very similar to (and is a type of) a weighted moving average. The major difference with the EMA is that old data points never leave the average.
•> EMAs are commonly used in conjunction with other indicators (stochastic, RSI etc) to confirm significant market moves and to gauge their validity. For traders who trade intraday and fast-moving markets, the EMA is more applicable.

•> The EMA responds more quickly to recent price changes than the SMA.

Disclaimer: The author is Head - Technical & Derivative Research at Narnolia Financial Advisors. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
First Published on Sep 22, 2018 10:24 am
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