How exponential moving averages work

There is a debunked myth that banks are
following some kind of ‘magical moving average.’ They think that somewhere
there is a moving average that cannot miss. But nothing could be further from the
truth. Like anything else, a moving average is a tool that traders use to
define a trend and perhaps look for potential support and resistance areas.


EMA means Exponential Moving Average. And to
know more about this, we need to understand first the simple moving average.

The moving average is the plotting of the
average price over the last defined number of candlesticks. Likely, it is the
average price in the previous 20 candles, 50 candles, 100 candles, etc. 

The trader can choose the number of candles
they wish to look back at. As moving averages can use the open, high, low, or
close price of the candlestick, 99.9% of the time, some people will use them
applied to these candlesticks’ closing prices.

Then, the simple moving average or SMA is the
straightforward version of moving average calculation. To elaborate, if the 20
SMA is plotted on the chart, it will show the average price at the closes of
the previous 20 candlesticks. When the market advances to generate another
candlestick, it would adjust the calculation to include only the immediate last
20 candlesticks, and so on.

As they take the average closing prices, add
them, then divide them by 20, the SMA shows its calculated value. After that,
it would plot the chart’s calculation, making a line through the dots to make a
longer line across the chart’s width.

With that, the EMA in forex trading is similar, except the formula is
mathematically weighted to have more emphasis on the most recent candlesticks.
This causes this kind of moving average to be more immediately sensitive to
price fluctuations. Thus, it would change direction faster.

How It Works

There are different ways to use EMA in forex
online trading. And to be honest, one’s imagination might be the only limit.

  • As
    a Measurement of Trend

In the most basic form, traders typically use
the EMA as a measurement of the trend. To put it simply, if the moving average
is increasing over time, then it is assumed that the trend is also very
positive. On the other hand, if a moving average is shifting lower over time,
then the market is being bearish or negative.

  • As
    Dynamic Support or Resistance

Several traders will use specific EMAs as
dynamic support and resistance. And this is because there are a few very widely
followed Exponential Moving Averages. Generally, they harken back to the days
of stock trading. Now, some of the most common ones are the 20-day EMA, 50-day
EMA, 100=day EMA, and 200-day EMA.

Using these specific round numbers is
psychological and goes back to the early years of technical analysis. So, it is
more or less a convention than anything else. As traders go on in their online
trading career, they see moving averages that people insist perform better than
others. But in the end, it would always be a personal preference issue.

Shorter-term traders tend to go on smaller
numbers line the 9 EMA. And this is because it is so fast to react in
comparison to something like the 50 EMA. But for the longer-term traders, they
must pay more attention to higher numbers because it gets much more details and
movement to change the direction of the moving averages. Therefore, it keeps
the trade for much more extended periods of time.

Some traders use this type of set up to
guarantee that they are trading with a number of traders as far as the trend is
concerned. Also, they would only trade in the direction of all moving averages
and only if they are moving in the same manner.

One more way to use the EMA as an indicator is
through a crossover system as a trading strategy. This has become one of the
most basic online trading systems existing. And by its very nature, it must
have a trend to be profitable. They do this by using two moving averages: a
short-term moving average and a longer-term moving average.

The concept is that if the shorter moving
averages cross over the 200-day EMA, traders should look to take long trades.
Contrarily, if the 50-day EMA crosses below the 200-day EMA, traders should go
for the short trades.

Other traders use this as a mechanical system
to simply make trades with no filter whenever the crossover happens. The main
issue with this is that it requires a strong trend for it to work. And in a
ranging market, there are many whipsaw trading – causing repeated small losses.
However, this would eventually get a strong trend and generate more enormous
profits. It takes a specific type of psychology to trade with this system over
the long term.

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