A:

The exponential moving average (EMA) is a weighted moving average (WMA) that gives more weighting, or importance, to recent price data than the simple moving average (SMA) does. The EMA responds more quickly to recent price changes than the SMA. The formula for calculating the EMA just involves using a multiplier and starting with the SMA.

[Note: Simple and exponential moving averages are just one form of technical analysis. Successful traders use many forms of technical analysis to make informed decisions. Investopedia's Technical Analysis course will show you how to use both chart patterns and technical indicators to identify opportunities and manage risk with over five hours of on-demand video, exercises and interactive content.]

The calculation for the SMA is very straightforward. The SMA for any given number of time periods is simply the sum of the stock's closing prices for that number of time periods, divided by that same number. So, for example, a 10-day SMA is just the sum of the closing prices for the past 10 days, divided by 10.

The three steps to calculating the EMA are:

  1. Calculate the SMA.
  2. Calculate the multiplier for weighting the EMA.
  3. Calculate the current EMA.

The mathematical formula, in this case for calculating a 10-period EMA, looks like this:

SMA: 10-period sum ÷ 10

Calculating the weighting multiplier: [2 ÷ (selected time period + 1)] = [2 ÷ (10 + 1)] = 0.1818 or 18.18%

Calculating the EMA: [Closing price-EMA (previous day)] x multiplier + EMA (previous day)

The weighting given to the most recent price is greater for a shorter-period EMA than for a longer-period EMA. For example, an 18.18% multiplier is applied to the most recent price data for a 10 EMA, whereas for a 20 EMA, only a 9.52% multiplier weighting is used. There are also slight variations of the EMA arrived at by using the open, high, low or median price instead of using the closing price.

Using the EMA: Moving Average Ribbons

Traders use moving averages in devising their trading strategies. They do this via moving average ribbons, which plot a large number of moving averages onto a price chart. Though seemingly complex based on the sheer volume of concurrent lines, ribbons create an effective and simple way of visualizing the dynamic relationship between short-, intermediate- and long-term trends. Traders and analysts rely on ribbons to identify turning points, continuations, overbought/oversold conditions, to define areas of support and resistance, and to measure price trend strengths..

Defined by their characteristic three-dimensional shape that seems to flow and twist across a price chart, moving average ribbons are very simple to create and interpret. They generate buy and sell signals whenever the moving average lines all converge at one point. Traders look to buy on occasions when shorter-term moving averages cross above the longer-term moving averages from below, and look to sell when shorter moving averages cross below from above.

To construct a moving average ribbon, simply plot a large number of moving averages of varying time period lengths on a price chart at the same time. Common parameters include eight or more moving averages and intervals that range from a two-day moving average to a 200- or 400-day moving average. For ease of analysis, keep the type of moving average consistent across the ribbon – all EMAs, for example.

When the ribbon folds – all of the moving averages converge into one close point on the chart – trend strength is likely weakening and possibly pointing to a reversal. The opposite is true if the moving averages are fanning and moving apart from each other, suggesting that prices are ranging and that a trend is strong or strengthening.

Downtrends are highlighted by shorter moving averages crossing below longer moving averages. Uptrends, conversely, show shorter moving averages crossing above longer moving averages. In these circumstances, the short-term moving averages act as leading indicators that are confirmed as longer-term averages trend towards them.

The number and type of moving averages vary considerably between traders, based on investment strategies and the underlying security or index. But EMAs are especially popular, because they give more weight to recent prices, lagging less than other averages. Some common ribbon examples involve eight separate EM lines, ranging in length from a few days to multiple months.

RELATED FAQS
  1. How do I use exponential moving average (EMA) to create a forex trading strategy?

    Learn how to use the exponential moving average (EMA) to create a dynamic forex trading strategy. Read Answer >>
  2. How do I use moving average to create a forex trading strategy?

    Learn a simple forex trading strategy that uses multiple moving averages (MAs) and is designed to create low-risk, high-reward ... Read Answer >>
  3. What are the main advantages and disadvantages of using a Simple Moving Average (SMA)?

    Examine some of the potential advantages and disadvantages involved with the use of a simple moving average or an exponential ... Read Answer >>
  4. Which periods are used most commonly in creating moving average (MA) lines?

    Learn the most commonly selected periods used by traders and market analysts in creating moving averages to overlay as technical ... Read Answer >>
  5. What is the Moving Average Convergence Divergence (MACD) formula and how is it calculated?

    Learn the formula for the moving average convergence divergence momentum indicator and find out how to calculate the MACD ... Read Answer >>
  6. What are the main advantages of using moving averages (MA)?

    See why moving averages have proven to be advantageous for traders and analysts and useful when applied to price charts and ... Read Answer >>
Related Articles
  1. Trading

    Simple Versus Exponential Moving Averages

    These technical indicators help traders visualize trends by smoothing out price movements, but they are based on different calculations.
  2. Trading

    How to Use a Moving Average to Buy Stocks

    The moving average (MA) is a simple technical analysis tool that smooths out price data by creating a constantly updated average price.
  3. Trading

    This Indicator Should Always Be Part Of Your Strategy

    The relationship between price, 200-day EMA and its slope of generate useful patterns that assist in price prediction and trade management.
  4. Trading

    The Most Important Moving Averages For Investors (AAPL, TLT)

    Investors focus on fundamental criteria to choose portfolio candidates but adding moving averages to their analysis will improve long-term performance.
  5. Trading

    Weighted Moving Averages: The Basics

    We take a closer look at the linearly weighted moving average and the exponentially smoothed moving average.
  6. Trading

    The Force Index For Short- and Medium-Term Trading

    Here are the guidelines for making trading decisions using the force index in both perspectives.
  7. Trading

    Adjusting Strategies to Moving Average Slopes

    Managing interrelationships between price, moving averages and slope can shift the reward:risk equation in your favor.
  8. Trading

    Tackling Technicals For Beginners

    Choosing the right indicators can be a daunting task for novice traders. It’s a much easier process when they focus their effects into five categories.
RELATED TERMS
  1. Exponential Moving Average - EMA

    An exponential moving average - EMA is a type of moving average ...
  2. Special Memorandum Account - SMA

    A special memorandum account is an account where excess margin ...
  3. Elder-Ray Index

    The Elder-Ray Index is a technical indicator developed by Dr. ...
  4. Moving Average Convergence Divergence - MACD

    Moving Average Convergence Divergence (or MACD) is a trend-following ...
  5. Moving Average Chart

    A moving average chart is used to plot average daily settlement ...
  6. Golden Cross

    A crossover involving a security's short-term moving average ...
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center