Exponential Moving Averages

Exponential Moving Averages

By creating a graph based from the moving average, it gives you a visual idea of the mathematical and scientific direction of market prices. It serves as a calculated indicator used to forecast future prices.

In our last post, we discussed about Simple Moving Average. Here’s another type of moving average we shall discuss, the Exponential Moving Average.

We will discuss how simple moving averages can be inaccurate at times and how exponential moving average can eliminate this distortion.

Let’s take an example:

Using the simple moving averages, the closing prices for 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

The sum of the five prices divided 5 will give you the simple moving average of 1.3209.

However, what if we change the ending price of Day 2 to something sporadic; say closing price on Day 2 is 1.3000. Let’s take a look how it will have an impact to our 5-day SMA.

It will be computed as follows:

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

This gives you the impression that the price was actually going down because of a lower result from the SMA. When in fact, it is only the Day 2 which caused this change.

This is because SMA can be too simplified that it overlooks one-time periodic and erratic change like this. The remedy – Exponential Moving Average!

Exponential Moving Averages attribute more weight to the most recent periods technically giving more value or importance to the recent closing prices,  putting more emphasis on what traders are doing recently.

In our example above, Days 3, 4, and 5 would have more weight than Days 1 and 2. With Day 2 having lesser weight, the spike caused by the price on Day 2 would have lesser impact using the EMA than it would using the SMA.

Here’s a 4-hour chart of USD/JPY showing side-by-side comparison of SMA and EMA:

 

exponential moving averages

exponential-moving-averages chart

This shows that the EMA represents the price actions more accurately than SMA putting more emphasis to the more recent incidences.

When trading it is important to pay attention to what traders are doing now, and Exponential Moving Averages help us realize this.

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