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EXPONENTIAL MOVING AVERAGE - TWO LINES
Doug Schaff
FX-Strategy
The moving average may be the most widely used indicator by traders, analysts and fund managers. The Exponential Moving Average is a more sensitive version of the simple moving average in that it calculates and plots an exponentially weighted average of prices from each of the most recent number of bars specified by the parameter used. This is done by use of the following formula:
EMA = EMA t-1 + SF * (Pricet - EMA t-1)
Where: SF = 2 / (1 + Length of Average)
Any new value will incorporate the current price along with the value from the previous bar and weighted by a smoothing factor, thus meaning an Exponential Moving Average gives greater weight to the market's most recent price and a reduced weighting to older prices. (Whereas, a simple moving average gives equal weight to all the prices in the series.)
Many users will use two moving averages to dictate trading signals. The faster moving average (measured over the shorter period) may be used as a proxy for price and thereby eliminate the short-term fluctuations in price action. Many analysts will then consider the crossover of the fast average above the slow average (a Golden Cross) as bullish and the crossover of the fast average below the slow average (a Dead Cross) as bearish.
To the right are two identical areas of price action in the 15-minute GBPJPY market. In the top chart two SMAs have been applied, 10 and 20 periods in length. In the bottom chart two EMAs have been applied, again 10 and 20 periods in length.
Note how the two sets of averages provide different signals.
At point A the 10 period EMA is already reacting to a rise in price and the general expectation is that it would cross over the 20 period average quickly. However, since the longer average is also reacting to the rise in prices, it also rises and by the time they cross at point B, the SMAs have also crossed.
Note the complete difference in spread between the different moving averages at C. While using a simple crossover as an entry signal would have caused a loss using SMAs, it is very unclear whether there would have been any benefit from using the EMAs.
However, as expected, subsequent to this sideways move the EMAs provided a buy signal 3 or 4 days prior to the SMAs crossing.
Thus there are benefits to using an Exponential Moving Average but as with any indicator it is important to understand how they react in different circumstances.
