Exponential moving averages (EMA) are extremely useful in technical analysis as they help a trader to divide the market into bullish and bearish market, therefore being decisive in showing when and where to trade.
What is an EMA?
An EMA is different than a SMA (Simple Moving Average) in the sense that, if you choose to apply the EMA on a shorter period it shows the EMA levels moving and therefore making the whole system more accurate.
Trading ForexWith Moving Averages
Trading with moving averages implies putting different ones on the chart and looking for the cross between the averages, with the lower EMA to act as a leader.
Therefore, when the lower EMA moves below the bigger one, the cross is called a bearish cross and we should go short (SELL contacts). Of course, a bullish cross would be that the smaller EMA crosses above the bigger one, and we should go long (BUY contracts / CALL options) on any pullback into the two averages.
Moving averages has a big advantage in front of other indicators as they are being applied directly on a chart, on prices. This is not possible when trading and interpreting market with oscillators and this characteristic makes them very popular among traders.
The standard interpretation is that as long as price is staying above a moving average it is considered to be bullish and any dip lower should be seen as an opportunity to BUY or to trade call options, and as long as price is staying below a moving average it is considered to be bearish and any spike higher into the moving average should be interpreted as bearish and an opportunity to SELL or buy put options.
The bigger the period the moving average is taking into consideration, the stronger the resistance or support price is facing. The bigger the time frame the moving average is being applied on, the strong the support and resistance and the bigger the expiration date should be, if binary options are traded.
SMA and EMA Differences
A classical example that shows the big difference between the EMA and SMA (Simple Moving Average) is to be seen when compiling the Bollinger Bands indicator. It is known that the Bollinger Band indicator shows the Upper Bollinger Band (UBB) and the Lower Bollinger Band (LBB) but few know that in the middle, the Middle Bollinger Band (MBB) is a moving average. Like any moving average, it can be simple (SMA) or exponential (EMA).
There are trading platforms that allow traders to choose what kind of moving average to use and this is important as SMA is more rigid while EMA is offering information close to reality and close to what price is doing. That being said, if price is staying in the upper side of the Bollinger Band, between UBB and EMA, by the time the EMA is being touched but not broken we should go and trade long /buy call options, and if price is trending between the EMA and LBB, by the time the EMA is being tested we should sell/ trade put options. In both cases, the expiration date should be updated and adjusted based on the time frame the indicators are being plotted.
Like mentioned earlier, being so popular, moving averages are being offered by any trading platform. The most popular one, the Metatrader, is having them under the Insert tab on the top left of the screen, then choosing Indicators and going into the Trend category the Moving Average indicator appears. It is a simple one by default, but it can be changed into an EMA when changing the settings.
Moving averages are considered to be trend indicators and when applied on the screen with different periods and multiple ones, different support and resistance levels appear. It is said that a perfect order of the moving averages on the screen is giving the market a trend looking like feeling as that is the time when price is moving. The trend is considered to be stronger as long as price is not touching any of the moving averages plotted. By the time a cross between two moving averages appears, it is considered that the trend is stalling and at least a correction is due.
Elliott Waves Analogies
In terms of Elliott Waves Theory, this means a 2nd or a 4th wave in an impulsive move is forming or market is finishing the c wave in a flat as this c wave is always an impulsive move of a lower degree.