Everything Exponential Moving Average

Using the Exponential Moving Average

As a fundamentals first, price action and volume second type of trader, I will be the first to admit that I detest traditional technical indicators. For me, having loads of coloured lines and filled standard deviation areas on my charts, just adds more confusion than clarity when I trade. Also, I find that a lot of the strategies that rely on technical indicators add a false sense of precision to trading. 

Does anyone truly believe that when one line crosses the second or another is above or below a certain level, there is some causal relationship in terms of where the price of an instrument or currency will go? Still, I must confess that there are a handful of technical indicators that I do use on a regular basis. One of them is the 200-period exponential moving average, commonly represented by the initials EMA.

Calculating the Exponential Moving Average

The key difference between a simple (arithmetic) and exponential moving average, is the former gives greater weight to recent closing prices over the rolling period in question. Calculating the exponential moving average requires finding the simple moving average first and then adding the relevant weighting for each individual period, which can be complicated and requires more historical data. 

If you want to calculate your own exponential moving averages manually, then check out this article for an in-depth walkthrough of how to do the calculation yourself. Thankfully, most charting platforms and trading platforms, like the VARIANSE’s cTrader, will do the calculator for you.

A Brief History

As a concept, the exponential moving average has been around for a long time. Development of the technique traces back to the forecasting work conducted independenly by Robert Goodell Brown and Charles Holt during their time in the US Navy during the 1950s. 

The first application in the field of financial trading, however, is credited to Pete Haurlen in the mid-1960’s, who also happened to be a bonafide rocket scientist by profession. Low computing memory at the time also made exponential moving averages, which unlike simple moving averages only required the prior calculation to be stored in memory, an ideal indicator for the age. 

Trend Filtering

Personally, I don’t use the exponential moving average to point forecast forex, or any other instrument. Most of the work done in terms of financial market research suggests that nominal forex rates, like many other types of traded instruments, do not mean revert. So any type of price averaging, whether it be simple or exponential, tends to be a poor predictor of future price. 

But I do use the indicator to judge whether or not to enter a trade and in what direction. For example, if the price of a particular forex pair is trading a healthy distance above the 200-period exponential moving average and the indicator is upward sloping, then I will seek opportunities to go long the pair when they arise. But I won’t seek to short the pair under those conditions. 

The opposite holds true if the pair or instrument is trading below a  200-period exponential moving average that is downward sloping. In this case I will seek to short the instrument, but would rule out any long opportunities.    

Were the price to be hugging close to the 200-period exponential moving average, or moving across it frequently, with the indicator having a flat slope, then I would seek to pursue more rangebound opportunities rather than any trend following ones.

Period Selection

Why select a 200-period exponential moving average versus say 100 period or even 199 period. In truth, it is entirely up to the individual trader what period to decide. Using shorter periods will pick up changes in trend more quickly, but also risks catching less significant moves in the market. Meanwhile, choosing longer periods risks missing out on trend changes completely.

I’ve settled on the  200 period for two reasons. Firstly, a lot of traders use the 200 period, which makes it self-fulfilling. Secondly, my past experience trying to overfit moving averages haven’t been all that successful.

Final Thoughts

Even if you aren’t the biggest fan of technical indicators, moving averages, and especially the exponential moving average, deserve consideration in any trading strategy. While my use case is pretty simple, there are plenty of trading strategies out there that build on more than just one moving average. Check the VARIANSE cTrader platform where you can choose from a host of different types of moving averages with various options in terms of settings.