Basic technical analysis of stocks uses formulas and algorithms that trace the past, and possible future, of stock prices. The exponential moving average, or EMA, built from a simple mathematical formula, is one of the most useful and popular chart indicators. Using the EMA, an investor can spot buy and sell signals and create a personal technical system for trading stocks.
A moving average is a number calculated from the sum total of closing prices over a defined period. A 50-day simple moving average, or SMA, for example, adds up the closing prices over the past 50 trading sessions, then divides that result by 50. The result can be plotted on a price chart; the movement of the line traced out by the SMA from day to day shows the recent trend in the average closing price. An SMA line moving up shows a stock that is rallying; a downward trending SMA shows a falling stock.
An exponential moving average places more mathematical weight on more recent trading days. The closer to the present day, the more accurately the EMA indicates the recent price trend. The longer the period covered by the EMA, the lower the relative weighting for recent trading.
EMA and Charting
If you trade online, your broker will probably offer some basic technical tools that you can display along with the simple price chart. By selecting the SMA and EMA, you can follow these indicators as they change over time. The software will allow you to set the parameter: the number of days you want each indicator to cover. The shorter the period, the closer the moving average will follow the price. The longer the period, the more gradual the moving averages change and the smoother the line appears.
EMA and Trading Tactics
By plotting both EMA and SMA on a price chart, you can spot a possible turn in a stock price. When a short-term EMA crosses over a longer-term SMA, the price is reversing from its recent trend. In addition, a long-term moving average will provide an indication of price support (when a stock is falling) and price resistance (when it's rising). Many traders watch these support or resistance points closely and enter a trade as soon as the price either breaks through the trend line or bounces against it and reverses.
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