What is EMA
The exponential moving average indicator, also known as EMA, is a technical chart indicator that tracks the price movement of an instrument over time. It is a type of a moving average indicator and it is one of the most popular trading indicators, used by thousands of traders. EMA is a weighted moving average indicator and it gives more importance to recent price data, when compared to a simple moving average. Because of its unique calculation, the EMA indicator will follow prices more closely than a typical simple moving average.
How Does EMA Work
The exponential moving average indicator averages the past prices of an instrument, however it uses a weighting approach to emphasize more on the recent price action rather than the past price activity. In contrast to a simple moving average, where all prices are treated equally, recent price changes play a much larger role in the calculation of the exponential moving average results compared to older data. Exponential moving averages are used to identify trends and reversals as well as outline important support and resistance levels.
To add an exponential moving average indicator in cTrader Fondex, follow the steps below:
- Right Click on the chart and navigate to Indicators > Exponential Moving Average
- Click on the Exponential Moving Average indicator and the following will pop up
- Select Source, Periods and Shift and click OK. The indicator will be plotted on your chart
The formula to calculate an exponential moving average is pretty straight forward. We can see the equation used for the calculation of the EMA indicator below
EMA = Price(n) * k + EMA((n - 1) * (1 - k)
EMA = Current value of the exponential moving average indicator
n = Current bar
k = 2 / (Periods + 1)
Exponential moving averages are used in a variety of ways to interpret and understand trending markets as well as anticipate trend reversals. Sometimes they are also used to identify important support and resistance levels, due to the fact that recent prices play a much more important role in the calculation of the EMA values. EMA indicators are particularly sensitive to recent price changes, especially when compared to a typical simple moving average indicator, therefore they are a preferred indicator when it comes to identifying price reversals, breakouts and new trend formations. In the sections below, we highlight some of the most popular ways to use exponential moving averages in trading.
EMA Golden Cross and EMA Death Cross
One of the simplest and most popular ways to use exponential moving averages in trading is the golden cross and death cross strategy. These strategies use a combination of two EMA indicators plotted on the chart. A golden cross occurs when a faster - 50 period exponential moving average crosses above a slower - 200 period exponential moving average from below and a death cross occurs when a faster - 50 period exponential moving average crosses above a slower - 200 period exponential moving average from above. Below we can see two examples, one of an EMA golden cross and one of an EMA death cross, taken from Fondex cTrader charts.
A golden cross between the two EMAs is usually considered a signal for the formation of a bullish trend. The short term EMA serves as a trend direction indicator while the long term EMA identifies a strong resistance level. In the scenario above, the short term EMA has reversed direction, and as soon as it crosses the longer term EMA from below, breaking the resistance level, we have an indication that higher prices will follow.
On the opposite side, a death cross between the two EMAs might be the signal for the formation of a bearish trend. Again, the short term EMA serves as a trend direction indicator but in this case the long term EMA identifies a strong support level. In the death cross scenario above, the short term EMA has taken a downwards path and as soon as it crosses the longer term EMA from above, breaking the support level, we have an indication that lower prices should be expected.
Exponential moving average ribbons are a collection of exponential moving averages of different lengths that are added on the same chart to form ribbon-like indicators. EMA ribbons are used to evaluate the strength of a trend. The strength of the trend is determined by looking at the distance between EMA indicators. The wider the distance between the EMA, the more strength the trend is gaining. EMA ribbons are also used to identify key areas of support or resistance by looking at the price in relation to the ribbon. Finally, EMA ribbons can be used to signal potential trend changes when the price moves through the ribbons, or the ribbons cross each other. Below we can see an example of EMA ribbons plotted on Fondex cTrader.
Three EMA Crossover Strategy
The three EMA crossover strategy is another very popular trading strategy consisting of three EMA indicators plotted on the chart. The most usual setup consists of a short term EMA at 9 periods, a medium term EMA at 21 periods, and long term EMA at 50 periods. The Triple EMA crossover strategy signals a buy as soon as the short term EMA is higher than the medium term EMA and the medium term EMA is higher than the long term EMA. When the short term EMA is back below the medium term EMA, the strategy signals an exit from the position. The opposite is true for short trades. Below we can see some examples of buy and sell signals using the three EMA strategy.
In the chart above, we can observe that as soon as the 9 and 21 period EMA indicators cross below and above the 50 period EMA indicator - a trend towards the respective direction is formed, confirming the validity of the respective signals.
Limitations of the Exponential Moving Average
The exponential moving average indicator, just like any other technical indicator, needs to be used in context. EMA indicators can generate a lot of false signals that could lead to substantial losses if used out of context. Therefore, when using EMA indicator strategies, always consider the market fundamentals that currently move the market and combine the signals with other confirmation signals, like oscillators, support/resistance levels and the relevant price action taking place on the chart.
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