An Exponential Moving Average or EMA is a tool used by traders and stock analyst to try and determine which way a stock’s price (or index) will tend to move. The tool uses historical data and, though not entirely failsafe, it has a tendency to be quite prescient.
An EMA’s distant cousin is the Simple Moving Average or SMA. To calculate an SMA, one would simply (pun intended) add the closing prices for the given moving average to be calculated and then divide by the same number. For example: To calculate the 200-day SMA (one of the most commonly used SMAs) one would take the most recent 200-day closing prices, add them together, and then dividing by 200. The calculation shows the average price for the last 200 days, which could then be plotted on a graph or chart. Using this information, traders can gauge which way a stock’s price is trending. To calculate the 200-day EMA a similar process is used but more weight is given to the latest data. Thus, EMA’s react faster to price changes than do SMAs. For an a excellent video tutorial on how EMAs work click here.
EMA crossovers occur when one EMA crosses above or below another (e.g. the 50-day EMA crosses either above or below the 200-day EMA). As can be seen in the chart to the left, the 50-day EMA (red line) crosses below the 200-day EMA on 8/17/2011, and it crosses above the 200-day EMA on 1/5/2012. More importantly, however, is what happens after the events occur. In the case of the August 2011 downward crossover, the price of the S&P 500 index plummeted, eventually settling at a low of 1074.77 on 10/4/11. In the case of the January 2012 upward crossover, the S&P 500 index began a nice march upward and ended its climb with a high of 1,422.38 on 4/2/12. Since EMAs react much more quickly to price changes, many traders will use SMAs in combination with the EMAs to verify price trends.
Personally, I like to watch for EMA crossovers and use the information they provide to determine when I need to hedge my portfolio. Two of my favorite shorting instruments are the ProShares Short S&P 500 (SH) and the ProShares UltraShort S&P 500 (SDS) ETFs. Both offer an easy and relatively straightforward way for me to short the market and hedge my portfolio; and, since shorting any investment instrument carries unlimited risks, I can limit my exposure to both ETFs by using options, which are available for both ETFs.
Bottom Line: No one person can know for certain which way the market or the economy will go but, with tools like EMAs, traders can gain a sense of which way prices will trend over short to medium-term time horizons.
