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.)

A moving average is generally used for identification of the underlying trend. Some users consider a rising moving average value and price positioned above the moving average would indicate an uptrend. A declining moving average value and price positioned below the moving average would indicate a downtrend.

Note how the EMA is more sensitive to current price than a simple moving average (SMA). The above chart displays the EMA in purple along with an SMA in green. It can be seen that during the rally to the center left of the chart the EMA rises more quickly than the SMA, reacting to the acceleration in price. This is due to the fact that the weighting for recent bars is greater than those of 21 periods prior. Then, when a correction sets in, while the SMA continues higher as it gives equal weighting to all bars, the EMA flattens out quickly in reaction to the sideways move.

While this does appear to be an advantage, it should also be borne in mind that sometimes if the EMA reacts too quickly, it could provide a false signal if price makes a correction but quickly resumes a trend.