Getting ahead in the markets requires a detailed series of strategies and the ability to adapt, but as a smart trader, you already know that.
What you may be interested in, however, are the tools that allow you to adapt your strategies with a greater degree of accuracy and success than previously. Particularly in cases where you want to react at speed to price changes, having the right tools becomes essential. 
The Exponential Moving Average (EMA) is just such a tool, and it’s going to be our point of focus today. In just a couple of minutes, you’ll see why it matters, how it works, and how it compares to some of the other options you may have already considered.
Defining the EMA
The EMA is designed as an alternative to the SMA approach that every trader will be familiar with. While the SMA does provide some information about how the price of an asset has changed over time, it doesn’t include any relative weighting as part of its calculation.
The problem with this is that the most recent price changes — which may have the biggest influence on future prices — are treated exactly the same as price changes from earlier in the trading session. This means traders are less likely to be able to accurately react to sudden price changes if they stay focused solely on the SMA.
An EMA solves the weighting problem by giving more weight to the most recent price changes. The idea is that the most recent events are better predictors of what is about to happen next.
One potential drawback of this approach that every smart trader will be aware of is that the EMA can become less accurate in highly volatile markets.
If the price is rapidly moving up and down with no clear pattern, the short-term bias of the EMA increases the chances of it producing false signals. That said, with the right application, there are significant advantages.
The benefits of EMA trading strategies
Pursuing EMA trading greatly reduces the lag that can occur when traders enter and exit positions rapidly. This means that momentum-based trading strategies that rely on the timely and accurate identification of future trends and changes in direction become more efficient:
- Calculating the EMA helps spot short-term price directions better than an SMA approach
- The EMA can also be used to identify possible changes in pressure and dynamic support
- EMA strategies naturally align with the use of other momentum-based indicators
The point here is not that the EMA approach is perfect, but that it allows for significant improvement. Combining the information it provides with other indicators, such as the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD), can be highly effective.
Spotting momentum with EMA strategies
Smart traders use platforms like ThinkMarkets to connect them with the comprehensive range of tools they need. What they see is that the EMA allows them to understand the following key things about any asset they are looking to trade:
- Prices that sit above the EMA indicate an uptrend that could continue to push the price higher in the immediate future
- A price that is below the EMA value suggests a downtrend is occurring and that prices will drop somewhat in the next few minutes
While the direction of a future trend is certainly important, it’s the strength of the trend that a sophisticated trader is more interested in. Knowing the trend strength allows you to calculate your risk exposure as you enter or exit a position:
- The gradient of the EMA tells you the trend strength so that you can estimate when a reversal may be set to occur
- Steep EMA gradients indicate more momentum; shallower EMA gradients are a sign of less momentum
The fascinating thing about this is that if you track the gradient of the EMA across time, you can then measure how the momentum is rising and falling in the market.
On shorter time scales, the size of the uptrend or the downtrend may be small, but you can still measure the momentum to see whether it is building or dissipating.
It’s this type of insight that is largely missing if you stick solely to the less informative SMA approach.
SMA vs EMA strategies for savvy traders
Trading over short timeframes in markets that are experiencing price rises and falls is something that you will have much more success with when using an EMA strategy.
Many traders choose to experiment with the chart size, but a figure of around a 5-minute window is typical of what professional traders choose to use when trading on behalf of institutions.
If you are trading for yourself and have previously focused the majority of your analysis on the SMA, you may be surprised by how much more responsive the EMA is as a metric.
The introduction of time-based weighting allows it to react significantly faster to recent price changes, allowing you to accurately gauge the momentum of the market.
An SMA strategy can still provide value, but it will be best kept to larger chart windows and more stable assets.
The advantage in this instance is that the SMA smooths out recent fluctuations so that if erroneous noise happens on an otherwise predictable chart, the strategy isn’t pushed in a sub-optimal direction.
Comparison with other tools
EMA crossover strategies involve the direct comparison of two or more EMAs, where each EMA value is calculated across a different time period.
The idea here is to improve the accuracy with which you can identify buy or sell signals. For example, when a shorter-period EMA crosses above a longer-period EMA, this is a strong bullish signal that points to a potential uptrend.
If the opposite behavior is seen, a bearish signal is a sign that a downtrend is about to take hold of the market. The specific choice of EMAs allows you to optimize different strategies.
This can be done across everything from a short-term, opportunistic scalping approach to a longer-term trend analysis strategy.
Popular EMA crossover strategies
Highlighting three common crossover strategies that utilize EMAs will help to illustrate the point:
- The Golden Cross: When a 50-day EMA crosses above a 200-day EMA, this is a signal of a potential bullish reversal
- 9 and 20 EMA: Traders working on 5-minute charts often use the 9 EMA as it reacts rapidly to recent price movements, as well as the 20 EMA, which is more focused on a longer-term approach
- 5 and 20 EMA: 15-minute charts in need of accurate trend confirmation often benefit from the greater resolution of 5 EMA and the longer-term view of 20 EMA
EMA intraday charting can be highly effective on its own, but it can also be significantly improved with the addition of more information:
- Using the RSI to obtain early indications of potential trend changes alongside short EMAs, such as 5 EMA and 10 EMA, can work very well. This is because the EMA data allows the strategy to react far more quickly when prices change
- Because the MACD is the gap between two continually evolving EMA values, the addition of a MACD metric to the strategy will help provide a clearer overview of how prices are moving
- Elite traders focus more on the amount of data they can digest in a short period of time than they do on trying to find a single strategy that will put them in winning positions the most often. The more data at your disposal, the more you will be able to adapt to the continually evolving nature of the market.
Final thoughts
Spending time gaining a greater degree of familiarity with the EMA is vital for traders who want to take advantage of short-term fluctuations. Learning how to combine it with RSI and MACD data can enrich the strategy further and provide a more comprehensive view of the behavior of a trend line.
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