If you want to become a chart geek in stock market trading, one of the first steps in the lesson plan is to learn about moving averages. An exponential moving average, or EMA, is a stock chart tool investors use to watch trends in the price of a stock. An EMA is different than a simple moving average.
Stock Charts for Trading
To trade stocks using what you see on a stock chart, you will use a charting system that plots the price change as a vertical line or a bar covering a set period. Choose a time period based on how you want to trade; you may decide to use five-minute, 30-minute, one-hour, four-hour or daily bars. The resulting chart will show vertical bars, with each bar representing the prices for one period, such as a daily chart with one bar showing the price of one market day. The charting software will then let you add in different technical indicators that also plot on or below the price bars. You use technical indicators to help with your stock price predictions.
Simple Moving Average
Simple moving averages were among the first technical indicators. The SMA takes the average of the most recent closing prices back in time to a number you select and plots the average with each new bar on your stock chart, producing a smooth line near the price bars. For example, a 10-period simple moving average is a line showing the average closing price of the last 10 bars. When a new bar is started, the oldest price drops out of the average and the closing price of the last bar is used to update and plot the average at the new price bar.
An exponential moving average works the same as a simple moving average except that the most recent prices are given more weight in the average than the older prices. The result is a moving average line that more closely follows changes in the stock price as the bars form. The indicator gets its name because the charting software will reduce the weighting of older prices by an exponential amount compared to the next newest closing price. As a result, the EMA gives more weight to recent prices compared to an SMA, which gives equal weight to the prices in the moving average period.
EMA Trend Indications
EMA chart lines with different periods, such as a 10-period or 100-period EMA, can be used to clearly see stock price trends that may not be apparent in the forest of price bars. The slope of the EMA line shows whether the stock is in an upward or downward trend. When the price crosses an EMA line, traders often view the cross as a sign of price trend reversal. Shorter-period EMA lines can show whether the trend is changing, and longer-period lines -- of 50, 100 or 200 periods -- show price resistance and support levels.