Exponential Moving Average

What is the Exponential Moving Average?

Unlike the weighted moving average, where as a new price is added the oldest price point is removed, the exponential moving average includes essentially all preceding data; however, the impact of the older data still declines as new data is added. The exponential moving average uses a smoothing constant that varies with the period of the exponential moving average.

How does the exponential moving average produce a trading signal?

Although we would not recommend using the exponential moving average as the basis of a trading system, it is useful to be aware of the basic technique of trading around exponential moving averages. The principal of moving averages is that whilst the current price is above the average, then buying pressure is strong and the market can be considered to be in an uptrend. Conversely, with higher selling pressure, prices will drop below the average and the market can be considered to be in a downtrend. In its most simplistic form, trading signals are generated when these crossovers occur; when prices cross above an exponential moving average a buy signal is generated and when prices cross below the exponential moving average a sell signal is generated.

A more sophisticated trading system would change the period of the moving average depending on market conditions. A fast moving trending market would require a short period exponential moving average, whereas a choppy or sideways market would require a longer period exponential moving average to avoid being whipsawed in and out of positions. A guide to setting the period of moving average would be to set the length at half the length of a market cycle. For example, if the market cycle is currently 34 days, the period of the exponential moving average would be set at 17 days. Furthermore, to reduce whipsawing, signals may only be generated after the price has exceeded the exponential moving average by a certain percentage.

Using just one exponential moving average would still be considered a very simple system and normally leased to exponential moving averages would be used. Using several exponential moving averages, the signal is not generated when price crosses over the exponential moving average but when a short period exponential moving average crosses over a long period exponential moving average. In an ideal situation, the security price and all exponential moving averages will be lined up in order; in an uptrend the price would be on top, next would be the short-term exponential moving average, then the medium-term exponential moving average and then finally the long-term exponential moving average would be on the bottom. In a downtrend, this would reverse.

The exponential moving average is still a very blunt tool to use on its own for trading. To see how more sophisticated tools such as sentiment readings can be combined with traditional indicators such as the exponential moving average, visit our Trading System homepage.