In college, I took one statistics course in which we learned various topics such as means, linear regression, probability models, and a bunch of other mind-numbing topics that I thought I would never use again in my life! As it turns out, you actually rely on much of that information to help you in trading. It may sound complicated but with today’s technology, the trading platforms have tools to make all of the calculations for you. You just have to be aware of them. In a previous lesson, The Golden Cross vs. The Death Cross, I taught you the study of SMA (Simple Moving Average). In today’s lesson, we are going to talk about the second kind of moving average known as the Exponential Moving Average.
What is EMA (Exponential Moving Average)?
Recall that the simple moving average was a mean of a certain number of time periods in the past. For instance, a 50 day SMA would be the average closing price of the past 50 days. As we move forward in time, the mean is derived from the close of the most recent date.
The EMA functions much like the SMA in that it is an average of price over a period of time, however, the main difference is that each data point is weighed differently. More weight is given to the most recent data and the weighting decrease as you go farther back in time. In other words, EMA treats more recent data as more relevant data. This means that with a 50 day EMA there will be more weight given to the last 20 or so days then the previous 30.
The two most common types of EMA are the 50 and 200 day moving average and they are signals for upcoming trends in stocks.
Why EMA matters
Traders are always looking for signals to enter and exit a stock. EMA provides a good indicator of the trend of the stock. If the EMA line is moving up, then we can expect to see a rise in the stock price in the short term. If the EMA line is moving down, then we can expect to see a fall in the stock price in the short-term.
EMA can also be great indicators for support and resistance lines. Often times, stocks will find support or resistance with this technical indicator. A break above or below the EMA is a good signal in what direction a stock may be heading. For instance, if a stock is trending up and it breaks through the 50 day EMA, then we should expect further price movement upward in the short-term.
SMA and EMA are often looking in tandem of one another as well. EMA is considered a shorter-term indicator because of the weighting of the data points while SMA is considered more of a longer-term indicator. An extremely bullish trend occurs when the 50 day EMA crosses above the 200 day SMA. (Allows a shorter-term trend crossing above a longer-term trend). A bearish trend occurs with the 50 day EMA crosses below the 200 day SMA.
Adding EMA to Your Charts
Adding EMA to your charts should be very simple with whatever trading platform you are using. I’m going to show you how to add EMA with Schwab’s Streetsmart edge so you get a better idea.
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+Exponential Moving Average> Period 50 or 200
I stated this previously but always remember these indicators are just one piece of the puzzle. They do not guarantee the price movement of the stock but they give you a good idea of where it is heading combined with your other research.
Homework: Go on your trading platform and see how you can add the 50 and 200 day EMA’s to your charts. Look through multiple charts and see if you can find a recent cross of the 50 day EMA with the 200 day SMA.