Exponential Moving Average (EMA) Explained

As we have previously discussed and explained that, simple moving averages (SMA) can be twisted or misinterpreted by spikes. We have some examples below to start with.

Supposed we plot a 5-period SMA on the daily chart of EUR/USD.

The end prices for the last 5 days are as follows:

Day 1: 1.3172

Day 2: 1.3231

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

The simple moving average would be calculated as follows:

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

The simplification seems quite simple right？. Good, Let‘s see if there was a news report on Day 2 that causes the euro to drop across the board. This causes EUR/USD to plunge and close at 1.3000. Let’s see what effect this would have on the 5-period SMA.

Day 1: 1.3172

Day 2: 1.3000

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

The simple moving average would be calculated as follows:

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

Due to the change on Day 2 that causes Euro to drop, the newly simplified results of the SMA would be a lot lower and it would give you the idea that the price was actually going down when in reality, Day 2 was just a one-time event caused by the poor results of an economic report. The key objective we are trying to make is that, sometimes the simple moving average (SMA) might be too easy.

Unless you able to find a way that you could filter out these spikes, that you wouldnt get the wrong idea. Huh... just Wait..Yes ! Because there is a way named as Exponential Moving Average!

The exponential moving average (EMA) is a weighted average of recent period's prices. It uses an exponentially decreasing weight from each previous price/period.

Exponential moving averages (EMA) give more weight to the most recent periods.

In the above example the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.

This would mean that the spike on Day 2 would be of lesser value and wouldnt have as big an effect on the moving average as it would if we had calculated for a simple moving average. If you think about it, this really makes a lot of sense because it does put more emphasis on what traders are doing recently.

Exponential Moving Average (EMA) vs. Simple Moving Average (SMA)

Now Lets take a look at the 4-hour chart of USD/JPY to feature how a simple moving average (SMA) and exponential moving average (EMA) would look side by side on a chart.

Consider how the red line (the 30 EMA) seems to be a closer price than the blue line (the 30 SMA).

This means that it represents more accurately the recent price action. You can probably guess why this happens. Its because the exponential moving average drops more emphasis on what has been happening lately.

Note, When trading, it is far more important to see what traders are doing NOW rather than what they were doing last week or last month. Because thats the only way to get along.