Exponential Moving Averages (EMA) [EXPLAINED]

We are now moving on from Simple Moving Averages (SMA) to a bit less simple, Exponential Moving Averages. 

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 can be distorted? 

We’ll start off with an example.

Let’s say we plot a 5-period SMA on the daily chart of GBP/USD. The closing prices for the last 5 days are as follows:

Day 1: 1.2975
Day 2: 1.3015
Day 3: 1.2995
Day 4: 1.3171
Day 5: 1.3101

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 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 period SMA. 

Day 1: 1.2975
Day 2: 1.2900
Day 3: 1.2995
Day 4: 1.3171
Day 5: 1.3101

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. 

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!

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What are Exponential Moving Averages? 

Exponential moving average (EMA) is a technical indicator that gives more weight to the latest data when calculating the MA value at each point. 

The EMA 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.

Why do Forex traders use EMAs?

The EMA has been developed to facilitate a smoother transition between the time frames.

Reduction in the weight of price values 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 EMAs 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.

Exponential moving average

Let’s talk examples.

In fact, to make it easier, let’s use the example from above.

The EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.

This would mean that the spike on Day 2 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? This way, it is clearer to see what traders are doing NOW rather than what they were doing last week or last month.

Exponential Moving Average (EMA) vs. Simple Moving Average (SMA)

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.

Exponential moving average ema

See how the blue line seems to be a closer price than the black line?

That’s because it more accurately represents recent price action. 

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 Simple and Exponential Moving Averages and determine which one fits YOUR trading style better!

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