What are Exponential Moving Averages (EMA)?

W

e already pointed out the problem occurring with simple moving averages - they can give us false signals. But how does these Exponential Moving Averages help?

We will start by showing you first how SMAs can mislead you.  

Let see what we mean with the following example:

For instance, we will plot a 5-period SMA on the daily chart of EUR/USD.

The values of closing prices in the last 5 days are:

Day 1: 1.3172

Day 2: 1.3231

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

We will calculate the SMA by the formula from our previous lesson:

(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209

Let’s suppose that Angela Merkel announced publicly her success of adopting an ALIEN baby. Germany is shaking by the news that the chancellor has gone crazy and this led to a temporary fall of the price, closing at 1.3000 on Day 2. Let’s see how our calculations will change:

Day 1: 1.3172

Day 2: 1.3000

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

SMA = (1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163

The difference between the old SMA 1.3209 and the new SMA 1.3163 is not small at all. 

You could have started thinking that there is a reversal trend and the price is going down. 

But on Day 3 Merkel said that it was a horrible joke done by the Autocue and everything was back to normal.

The drop in the price was just for one day, influenced by the news report, but you won’t know that. 

Here it comes the solution to the problem: 

Use the Exponential Moving Average!

EMA forecasting is a popular method for modeling time series in the business world, as it works under many conditions.

Exponential moving averages give more weight to the most recent periods during the calculations.

If we take our example, the EMA would put more weight on the prices of Days 3, 4, and 5.

This will decrease the effect of the spike on Day 2.

Let’s take as an example a 4-hour chart of USD/JPY to see the difference between a simple moving average (SMA) and an exponential moving average (EMA).

Traders use the EMA to smooth out previous price data with the hope of taking advantage of the ongoing trend.

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What is Simple Moving Average (SMA)?

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Simple vs. Exponential Moving Averages

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