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Analysis

Exponential Moving Average (EMA)

by Dragan Stankovic
written by Dragan Stankovic

Apart from simple and weighted moving average, EMA or exponential moving average is among crucial factors influencing trade in Forex and other financial markets. With moving average in general being the most widely used tool for technical analysis, it is important to discern the different types and their importance, hence the topic at hand.

What is exponential moving average?

Well, like simple moving average, EMA is calculated using the sum of closing price figures over a number of periods and then divided by the number of said periods. The reason for this similarity is in the title “moving average”, and this is how (moving) average is calculated. However, this is where the “exponential” part comes into play. Unlike simple moving average, exponential moving average shifts the focus toward more recent results, rather than treating them equally. Basically, it means the last few periods are more important than the first few periods (or any periods in between), as the former spearhead the direction of the trend as well as the trend itself. The weight of data shifts as they grow older and new data come in, a process which happens exponentially – hence, the term exponential moving average.

exponential moving average

Why is it important?

Before modern computers were developed, simple moving average was the norm when analyzing things such as trends in financial markets. They were easy and straightforward, but they had flaws. Exponential moving average, among others, was a way to correct some of those flaws. Since the main point is to predict the future, rather than statistically describe the past, it stands to reason that recent results should carry more weight than the others. Thus, EMA came into play. It can predict future development with greater certainty than the simple moving average.

How does it work?

What makes exponential moving average so different from simple moving average is the mathematical formula used to calculate it. Without going into the grueling details, suffice to say each entry gets assigned with a weight index in terms of percentage: the latest entry gets, say, 18%, the previous one gets 15%, and so on while the first one (chronologically) gets, say 3%. The percentage amount never reaches 100% as the data flow is perceived to be indefinite. However, by assigning these percentages to respective entries, we get a result that may differ from the one from simple moving average, which treats all entries equally.

Conclusion

While there is no objective way to determine which moving average is more effective, or better (“better” being a subjective term in itself), this issue generally comes down to people who prefer simplicity and people who consider new and complex things are superior in the long run. The compromise would be to use all three types of moving averages: simple, weighted and exponential and look for matches: after all, if all three point to the same conclusion, surely it is more reliable than any individual moving average. But then again, it all depends on you.

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Analysis

Weighted Moving Average

by Dragan Stankovic
written by Dragan Stankovic

For a long time, simple moving average was considered the norm when it came to technical analysis in any field, including financial markets; however, several drawbacks have prompted the research and development of another technique, weighted moving average. This is especially true when it comes to exponential moving average, itself a highly specialized form of weighted moving average.

Why do we need weighted average in the first place?

The reason is simple: the previous model, simple moving average, only accounted for arithmetic average of closing prices over a number of time periods – usually days. By comparing simple moving averages, you could theoretically hazard a guess as to the direction and strength of a financial trend, while effectively nullifying any fluctuations that might throw you off. However, to most people, this would not even qualify as an educated guess, since the first and the last entry (as well as all entries in between) are treated equally. This would not be an issue if the goal was to analyze data statistically and preserve it for posterity; however, the goal is to use previous experience to guess future events, and this requires a different mathematical formula.

How does weighted moving average work?

The main difference between simple moving average and weighted moving average is the fact that the latter is biased toward certain entries and the former is not. Otherwise, the principle is the same: you add all entry values and divide the sum by the number of entries to get the average. However, weighted moving average usually involves a number of points (or percentages) which are added to entries based on how recent they are: the latest entry gets the biggest boost, the one before it gets a slightly smaller boost and so on. The oldest entry gets the smallest boost or none at all. Needless to say, simple moving average and weighted moving average of the same set of data need not necessarily show the same tendency, let alone the same result. As to which one is right, only time will tell.

How does one calculate moving averages?

weighted moving averageThe answer is simple: One does not. Most platforms will do it automatically for you, by displaying all kinds of charts, which unfortunately you need to learn to decipher. You will probably get to switch between simple, weighted and exponential moving averages at will, and base your trade decisions accordingly. Generally speaking, any one of them can be wrong, but all three… If they all agree on a general trend, it is usually a good sign, meaning this is a trend you can count on – theoretically. Usually just the simple and exponential moving average will suffice, as those are the most reliable ones available.

Conclusion

As for weighted moving averages, they are popular because they allow traders some freedom when assigning criteria for their own private analysis. Their versatility means you can make any kind of calculations and assign points. Usually, traders go for a variation called EMA.

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Analysis

Simple Moving Average

by Dragan Stankovic
written by Dragan Stankovic

There are two types of Forex traders and investors: those who prefer simple moving average, and those who prefer weighted moving average. While it is impossible to claim one of them as superior, it is possible to outline the qualities of simple moving average from the standpoint of those who prefer it.

What is simple moving average?

Simply speaking, simple moving average, or SMA, is the arithmetic average of closing prices over a number of days. In terms of Forex markets, simple moving average of a currency pair would be calculated by adding closing prices of said pair over a certain time period and then dividing the sum by the number of periods you used. For instance, if you are interested in a simple moving average of USD/EUR over the last ten days, you would look up the closing prices on each of those ten days, add them up, and divide that sum by ten – the number of days you were interested in. The result is the simple moving average of said currency pair.simple moving average

Why is it important for a Forex trader?

Forex trend trading may sound simple enough, but getting in at the right time and staying just long enough to make that sweet, easy money is nothing short of a form of art. There are numerous trade strategies, and some of the more successful ones rely on simple moving average, among other things. The importance of simple moving average for those strategies cannot be overstated. In fact, the 200 simple moving average is how you determine if a trend is long or not. The number 200 refers to the number of days. Anything above 200 simple moving average is considered a strong and rising trend, while everything below 200 simple moving average is considered a mark of a trend in decline. It is so universally accepted, that 200 simple moving average determines how a stock or a currency pair is perceived, which can have a profound impact on the market as well as your bottom line. Naturally, there are simple moving averages for any number of days, and they are usually used in conjunction, but the 200 simple moving average is considered the standard in modern markets.

A fair warning

A simple moving average is just an average of previous closing values, and as such, need not necessarily indicate anything in terms of future performance. There are no guarantees that the trend will follow the prognosis to the letter. However, a lot of people monitor these things, and do take these predictions very seriously. While the prediction itself may not even come true, a lot of people will act as if it will, which in turn may make it come true in real life. If simple moving average indicates an increase in future value and people start buying that financial instrument (having seen the SMA), it will, in fact, drive the price up, just as SMA predicted. Except it didn’t actually predict it.

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