Moving averages are used in technical analysis to figure out the average price movement of securities with time. Moving averages are determined from the total closing prices over a specific period.
Published on 19 December 2022
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The three primary types of moving averages include the Simple Moving Average, Exponential Moving Average, and Weighted Moving Average. In this article, you will be able to expand your knowledge about EMA in the stock market, its applications, and more.
Understanding Exponential Moving Average
EMA provides higher weightage to recent data points. EMA will react more significantly to recent price changes than SMA. For short-term averages, 12-day and 26-day EMAs are quite popular. For long-term averages, the 50-day and 200-day EMAs are primarily used.
EMA in the Stock Market
Now, you will find the answer to your lingering doubt of “what is EMA in stocks?” EMA in the stock market is useful for trading signals and analysis. Slopes in the EMA charts are useful for showing uptrends or downtrends. The 50-day and 20-day EMA charts are known to offer the highest amount of support and resistance to stocks.
The support level refers to the point at which the stock price begins falling. On the other hand, a stock price begins rising at the resistance point. The best time to enter a trade is when the price makes the trend line fall apart.
EMA in the stock market is useful for obtaining a trade direction. You can think about buying a stock when the EMA increases and the prices fall below the EMA or are close to it. Similarly, you can think about selling a stock when the EMA falls, and the prices are above or near the EMA.
You will be able to figure out the potential turn in stock prices by plotting the EMA and SMA on a price chart. The recent price trend reverses at the point where the short-term EMA and long-term SMA are crossing.
EMA Calculation
Before the EMA calculation, you will have to figure out the SMA and the weighted/smoothing multiplier of the previous EMA. SMA refers to the overall closing prices of a stock over a certain number of days divided by that exact number. For instance, the SMA for 40 days is the overall sum of the closing prices in the past 40 trading days divided by 40.
The multiplier for smoothing or weighting the EMA can be calculated using this formula:
*[2/ (chosen time period + 1)]
Therefore, for a 40-day period, the multiplier will be [2 / (40 + 1)]. It comes to an estimated value of 0.49.
The formula for calculating EMA in the stock market is as follows:
*[Closing price - EMA (last day)] * multiplier + EMA (last day)
Applications of EMA
EMA in the stock market is used for the following purposes:
● Highlighting Trends
Identifying price trends and emphasising them are the most crucial applications of an EMA. An increasing EMA proves that stock prices are on an upward trend, while a reducing EMA indicates a downtrend. EMA trading supports spot buying and signals by identifying price directions.
● Support and Resistance Bands
The EMA and other moving averages function as resistance and support levels for prices. Support levels are floors and serve as the limit till which prices are expected to fall. Resistance levels are ceilings and refer to the prices that are not expected to go beyond levels during downtrends.
Limitations of EMA
Since EMA depends on historical data, several arguments are present about its efficiency. Current prices provide the actual information about assets. Therefore, the historical data might not be useful for finding a future direction. Moreover, the emphasis on recent day limits also makes EMA biased to some extent.
How is EMA Different from SMA?
The SMA offers equal weightage to all values. However, EMA in the stock market only focuses on the most recent values. Therefore, EMA is more sensitive to recent price changes than SMA. It makes the results from the EMA more relevant according to the time. Therefore, EMA is often more popular among traders than SMA.
Parting Words
EMA is useful for technical analysis, but it needs to be calculated accurately. But traders should always keep in mind that moving averages don’t reveal the exact top and bottom of any trade. Moreover, every moving average has its own set of benefits and limitations. Therefore, the best moving average should always be picked according to the specific trading strategy.
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