The exponential moving average trading strategy explained.
Exponential Moving Average (EMA) is a type of Moving Average (MA) that places greater weight and significance on the latest data points.
Exponential moving averages are also referred to as exponential weighted moving averages.
Because the Simple Moving Average is still facing distortion when there is a spike of price movements, then with Exponential Moving Average this will be more minimalist.
Unlike the simple moving average, EMA can only react once to price change.
Many traders choose to use exponential moving averages in the Forex trading process.
The reason is that this type of average is more concerned with new data than old data.
And, EMA can react to recent price changes more quickly and can not be too dependent on old changes.
Where in it, EMA will be able to make a better quality-price chart refinement.
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Simple moving average calculation
In the previous chapter, we understood that simple moving averages often distort when there is a spike in price movements
This time we will try to explain this.
For example, we plot the 5-period SMA on the daily chart of EUR/USD.
The image above shows the closing price for the last 5 days is the first day at 1.3172, the second day at 1.3231, the third day at 1.3164, the fourth day at 1.3186 and the fifth day at 1.3293
Calculation simple moving average calculation will be like this:
1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293 / 5 = 1.3209
Then what if on the second day there was high impact news which caused the Euro to drop to the price level of 1.3000?
Well, we will see how it affects the value of SMA when there is a spike in price movements.
We again take the closing price data for 5 days because the SMA we take for example uses period 5, the first day at 1.3172, the second day at 1.3000, the third day at 1.3164, the fourth day at 1.3186 and the fifth day at 1.3293.
Then the simple moving average calculation will be as below.
1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293 / 5 = 1.3163
We can see the results of the simple moving average will be very low.
There is a sharp difference with when in the first case example,.
And this will give us an idea, that prices move downtrends.
But in fact, the events of the second day are just mere events that occur once.
As a result, the results of the news of bad economic conditions.
Thus we can take the conclusion that SMA is sometimes affected by movement spikes and this gives a false signal..
And from that condition, we hope that there is another way in which we can filter out such spikes so that we do not have the wrong notion of reading prices.
Exponential Moving Average calculation
The method of calculating the Exponential Moving Average or EMA has given more weight in the last few days, which is why the EMA smoothed price movements.
For this reason, EMA can reduce false signals due to price movement spikes.
In the example above, EMA will give more weight to prices in the last few days, on day three, four, and five.
This means that the spike on the second day due to the effect of high impact news will have a lower value and will not have a large effect on moving averages as if we had calculated simple moving averages.
Because traders place more emphasis on price conditions recently.
This makes sense because the EMA is not affected by spike price movements.
Exponential Moving Average vs Simple Moving Average
To clarify the difference between simple moving average vs. exponential moving average, in exponential moving average trading strategy, we will take the example of a pair USDJPY with a 4-hour timeframe
Take a look at the image below
In the example above you can see the 30 periods EMA with the red line.
And the 30 period SMA with the blue line, both of them are using the same period 30.
If we look at how the red line, which represents EMA 30, appears at the closest price compared to the blue line, SMA 30.
This means that EMA accurately displays the latest price movements.
Why is that? because EMA is more focused on what happened recently.
And since in trading, the most important thing is knowing what traders are doing NOW, rather than what they did last week or a month ago.
How to read the exponential moving average
The way to read EMA is the same as all moving average indicators, they are far more suitable for trending market conditions.
For example, if the market is in a strong and sustainable uptrend, the EMA indicator line will also show an uptrend.
Conversely, if a downward trend, the EMA line will also show a downtrend.
However, it should not only pay attention to the direction of the EMA line but also the relationship between the rate of change of the candlestick pattern.
For example, when the price action of a strong uptrend begins to weaken and reverse.
The rate of change in the EMA from one candlestick to the next will begin to decrease until the current indicator line is flat and the rate of change is zero.
Because of the lagging effect on the indicator, or even some of the previous candlesticks, the price action should have been reversed.
Therefore, observing that a consistent decrease in the rate of change in the EMA itself can be used as an indicator that can further counter the dilemma caused by the lagging effect of the moving average.
How to use exponential moving average
How to use EMA?
Most traders use peeriods12 and 26-day EMAs, the most popular short-term average used
Whereas 50 and 200 days EMAs are used as signals of long-term trends.
If EMA applied correctly it will lead to high profits, but if it is misinterpreted it will lead to losses.
An exponential moving average trading strategy tends to be more in calculating the average price at a certain time.
So the impact is more sensitive to price movements and moves a little more aggressively.
In interpreting the EMA, this technique is more appropriate if it is used for a trending market.
When the market is in an uptrend and is sustainable, the EMA indicator line will show an uptrend and a downward trend.
But you need to not only pay attention to EMA but also changes in candlestick pattern.
Exponential moving average trading strategy
EMA is one of the types of moving average indicators and many traders choose to use this indicator over SMA.
This is because EMA gives weight to recent prices, thus giving a signal for the current trend.
The common periods where many traders use are 12 and 26 by choosing a timeframe according to the trading style.
But maybe in trading practice, you will still encounter difficulties, because it can happen after you get the time to do the entry turns out the price suddenly against the position.
Therefore make it a habit to use a safe position size, and consider the risks in each trading plan.
Because there might be unexpected events in the market that you are not aware of, whether for political-economic news and with risk preparation from the start, you have made a good trading plan.