EMA's: Where They Belong in Your Trading Toolbox

The exponential moving average (EMA) is a less popular but more sophisticated version of the simple moving averages. You need a computer trading program such as FutureSource to employ an EMA indicator. With the EMA, more importance is put on the recent price action, but all the price data in the futures contract is used. I'll define the EMA below and then I'll discuss how I use and rank this trading tool in my "Trading Toolbox."

An EMA is another type of moving average. In a simple moving average, the price data have an equal weight in the computation of the average. Also, in a simple moving average, the oldest price data are removed from the moving average as a new price is added to the computation. The EMA assigns a weight to the price data as the average is calculated. Thus, the oldest price data in the EMA are never removed, but they have only a minimal impact on the moving average. The EMA calculation is achieved by subtracting yesterday's exponential moving average from today's price. Adding this result to yesterday's exponential moving average results in today's moving average.

The main use of the EMA indicator is its smoothing out function. In this way, the moving average removes short-term fluctuations and leaves to view the prevailing trend. This can be important because simple moving averages tend not to work well in choppy trading conditions.

Many trading programs display the EMA as a crossover trading system. For a crossover system, you may insert three different exponential moving averages. Generally, the lengths for these moving averages are short, intermediate, and long term. A commonly used system is 4, 9, and 18 intervals. An interval may be in ticks, minutes, days, weeks, or months; it is a function of the chart type. The closing price is used by most systems when calculating the exponential moving average. On many systems, however, you may specify a different price to use in the calculation (open, high, low, close, midpoint, or average price) by changing the computation of the EMA.

If the EMA crossover trading system is used, a buy signal occurs when the short- and intermediate-term averages cross from below to above the longer-term average. Conversely, a sell signal is issued when the short- and intermediate-term averages cross from above to below the longer-term average. Another trading approach is to use the "current price" method. If the current price is above the exponential moving averages, you buy. Liquidate that position when the current price crosses below your selected moving average. For a short position, sell when the current price is below the EMA. Liquidate that position when the current price rises above the EMA.

I use the EMA as one more "secondary" trading tool, along with most other computer-generated technical indicators that fall into that category. I use the EMA less often than simple moving averages. I use "secondary" trading tools to help confirm my ideas that are derived from my "primary" trading tools, which include trend lines, chart patterns, market psychology and fundamental analysis.