Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated with it. Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean: Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows: Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370 The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358 Simple enough right? Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 could have just been a one time event (maybe interest rates decreasing). The point I’m trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way! It’s called the Exponential Moving Average! Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.
When trading, it is far more important to see what traders are doing now rather than what they did last week or last month. Which is better: Simple or Exponential?First, let’s start with an exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. These can help you catch trends very early, which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits! The downside to the choppy moving average is that you might get faked out. Because the moving average responds so quickly to the price, you might think a trend is forming when in actuality; it could just be a price spike. With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go. Although it is slow to respond to the price action, it will save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good trade.
| SMA | EMA | Pros: | Displays a smooth chart, which eliminates most fakeouts. | Quick moving, and is good at showing recent price swings. | Cons: | Slow moving, which may cause a lag in buying and selling signals. | More prone to cause fakeouts and give errant signals. |
So which one is better? It’s really up to you to decide. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade. In fact, many trading systems are built around what is called “Moving Average Crossovers”. Later in this course, we will give you an example of how you can use moving averages as part of your trading system.
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