How Exponential Moving Average Works
The exponential moving average, or EMA, gives more weight to recent price data than the simple moving average, or SMA, enabling it to react and move more quickly than the SMA. The EMA is very popular in stock, futures and forex trading, and is often the basis of a trading strategy. A common trading strategy utilizing EMAs is to trade based on the position of a shorter-term EMA in relation to a longer-term EMA. For example, traders are bullish when the 20 EMA crosses above the 50 EMA or remains above the 50 EMA, and only turn bearish if the 20 EMA falls below the 50 EMA.
However, moving averages alone are rarely the totality of a trading strategy, and most traders complement their use of moving averages with other technical indicators. While it is difficult to determine the absolute "best" technical indicators to support a basic moving average strategy, a couple of the most common ones are trendlines and momentum indicators.
Momentum indicators, such as the average directional index, or ADX, or the moving average convergence divergence, or MACD, often indicate an upcoming change in market direction before the price moves far enough to cause a moving average crossover. Therefore, traders often use such momentum indicators as early warning signs that a market has either peaked or hit bottom. Combining both indicators can provide a robust trading system that alerts for both an entry (EMA crossover) and a take profit area (MACD/ADX).
Trendlines are also often used in conjunction with moving averages, as they can provide confirmation a market is in a trend or indicate it has entered a ranging area. Various trendlines drawn on a chart produce chart patterns, such as channels, triangles, etc., that can be used as additional indicators of possible future market direction.
Many traders depend heavily on the use of EMAs in their chosen trading strategies but usually include other technical indicators in their analyses as well.