An exponential moving average (EMA) is an average price calculation over a specific time period that puts more weight on the most recent price data causing it to react faster to price change. Traders use moving averages on charts to help determine trend, direction, and strength, and are often used as entry and exit points.
Moving averages tend to be most useful when a market or stock is in a strong trend with the moving averages acting as support as prices continue higher. Since moving averages use historical data, they are considered a lagging indicator—but they are great for understanding market sentiment and are great for confirming price action with other indicators like MACD or stochastics.
For example, if prices are trading above the moving averages then we know that, at that time, traders are more bullish than if they were trading below them.
Exponential Versus Simple Moving Averages
As you can see in the chart below the red moving average is a 20-day exponential moving average (EMA) and the yellow moving average is the 20-day simple moving average (SMA). The EMA sticks closer to the price action while the SMA is smoother and slower to react to the same price changes. Day traders generally prefer the EMA due to its quickness.
It is important to note the direction of the moving average for market direction for the time period you are trading. Generally traders want to trade in the direction of the trend to improve odds and go with the flow. The 8- and 20-day EMA tend to be the most popular time frames for day traders while the 50 and 200-day EMA are better suited for long term investors.
Sometimes markets will flat-line, making moving averages hard to use, which is why trending markets will bring out their true benefits. Moving Averages can also be beneficial for identifying reversals when stocks are over-bought or over-sold.
Generally stock prices will only get so far away from the moving averages before coming back to test the moving averages and then continue on their trend. Whether you are new to trading or have been doing it for a while, you will definitely find them to be beneficial in your trading.