We are now moving on from Simple Moving Averages (SMA) to a bit less simple moving average indicator, the Exponential Moving Average (EMA). But before we do that, let’s explore the reasoning behind why SMAs simply aren’t enough.
Remember how we mentioned that Simple Moving Averages (SMA) can be distorted in forex trading?
We’ll start off with an example.
Let’s say we plot a 5-period SMA on the daily chart of GBP/USD. The past performance closing prices for the last 5 days are as follows:
Based on recent prices, the simple moving average would be calculated as follows:
1.2975 + 1.3015 + 1.2995 + 1.3171 + 1.3101 / 5 = 1.3051
Simple enough, right?
But what would happen if there was a news report on the forex market on Day 2 that causes the pound to drop across the board? This would cause the GBP/USD to plunge and close at 1.2000.
Let’s see how it would affect the 5 periods of SMA.
Now, the SMA would be calculated as follows:
1.2975 + 1.2900 + 1.2995 + 1.3171 + 1.3101 / 5 = 1.2992
As we can clearly see, the result of the simple moving average would be a lot lower and it would give you the impression that the price was actually going down when in reality, Day 2 was just a one-off event caused by the poor results of an economic report.
The point is that SMA might simply be too simple.
Now, how awesome would it be if there was a way for you to filter out these spikes so that you wouldn’t get the wrong idea as part of your forex trading strategy?
Oh, wait… There is one!!
And it’s the name of this blog.
For the ones who are too lazy to scroll up, it is called the Exponential Moving Average! And it is a very popular indicator used by many traders.
Exponential moving average (EMA) is a technical analysis indicator that gives more weight to the most recent price data when calculating the MA value at each point. In other words, because the EMA indicator line has greater weight to more recent prices, it is more accurate in identifying a trend direction than other moving average indicators.
The EMA calculation formula is rather complex. Being the curious George that you are, you want to see it, don’t you?
Let me tell you though, it’s not fun…. Here it comes.
Exponential moving average = (Close – previous EMA) * (2 / n+1) + previous EMA
See? Told ya!
Essentially, it means that EMAs will give the most weight to the most recent price values and the closing price of the 1st candle will have almost no effect. As a result, the linearly weighted moving average line is a smoothing factor that helps a trader to identify trends and predict the future performance of financial instruments.
The Exponential Moving Average indicator has been developed to facilitate a smoother transition between the time frames. Reduction in the weight of price values of currency pairs as they move away resolves the SMA’s problems, where dropping the last price can affect the indicator more than adding the new one.
As a result, this makes the EMA more responsive to changes in price and also acts in smoothing out the line. To illustrate the emphasis placed on newer data, the below table shows the percentage of the EMA that is made up by each of the price bars. 10 price bars are used for this particular example.
Let’s take examples. In fact, to make it easier, let’s use the example from above.
The EMA would put more weight on the more recent prices, which would be Days 3, 4, and 5. This means that the previous day has more weight than the first trading day. It also means that the spike on Day 2 price action would be of lesser value and wouldn’t have as big an effect on the moving average as it would if we had calculated for a simple moving average.
It makes a lot of sense, don’t you think? With this trading strategy, it is clearer to see what traders are doing NOW rather than what they were doing last week or last month.
A picture speaks a thousand words so let’s take a look at a simple moving average (SMA) and exponential moving average (EMA) side by side on a chart.
See how the blue EMA line seems to be a closer price than the black line? That’s because it more accurately represents recent price action and has greater weight on most recent days.
And when you’re trading, you want to know what is happening NOW, not last week or month. But more on that in the next chapter! We’ll compare the Simple Moving Average and the Exponential Moving Average and determine which one fits YOUR trading style better!