How to Trade Stocks Using the Exponential Moving Average (EMA)
Moving averages are the most popular indicators for trading stock market trends. In general, stock markets are considered bearish if they are below the moving average and bullish if they are above.
Investors who employ technical analysis find moving averages very useful, and therefore observe the price in relation to the moving average to guide their trading decisions. They also gain an edge by ensuring that share prices of their positions are trading above the moving average.
A simplified EMA trading strategy is to remain on the buy side as long as the price remains above the moving average. If the price falls below the moving average, you should be defensive and may even sell short the position for as long as the price remains below its moving average.
Why Use an Exponential Moving Average
While the 200-period Simple Moving Average, or 200 SMA, is popularized in mainstream media, the more reliable moving average is actually the 200-period Exponential Moving Average, or 200 EMA.
The advantage of the EMA compared to the SMA is that it’s a weighted moving average and therefore reacts faster to recent price changes.
The 200 EMA is used as signal of long-term trends. When the market is in a strong and sustained uptrend, the EMA line will also show an uptrend and vice-versa for a downtrend. Use the EMA to determine trend direction, and trade in that direction.
Moving averages can act as support or resistance when the price gets close to it. Prices can be rejected or ‘bounced’ off at the 200 EMA which is considered as a sign of continuation of the long-term trend. Such bounces are opportunities to open a position where the risk is the lowest and the reward potential is the highest.
Long-term oriented investors also avoid using the 200 EMA in the daily time frame and instead use the 200 EMA in the weekly and monthly time frames. Stock market trends in the weekly and monthly time frames are less sensitive to short-term volatility than in the daily time frame.
How to Trade the 200 EMA
When the EMA rises, you may consider buying when the price dips near the EMA. When the EMA falls, you may consider selling when price rallies towards the EMA. You can use the 200 EMA in a trading strategy to trade stock market trends profitably.
When the price crosses its 200 EMA from below or from above like a ‘hot knife through butter’, it’s an indication that the sentiment has reversed from bearish to bullish or from bullish to bearish, respectively. Because many market participants are observing the 200 EMA, it makes trading trends even more reliable.
EMA Trading Strategies with the 200 EMA
When you look at a stock’s chart, you want to find instant orientation to be able to make educated investment decisions. You cannot make effective investment decisions if your chart is cluttered with indicators. Professional money managers have trimmed their charts down to only a few focus indicators. One of them is the 200 EMA.
The reason why a 200 EMA trading strategy works so well is because market participants are moving in a sphere of tremendous lack of certainty. If a stock price floats around erratically, it’s difficult to stay focused on fundamental valuations of the underlying business.
What the 200 EMA provides is a benchmark at which market participants can re-assess the fundamental valuations and ‘vote’ on the path forward. It can therefore benefit the fundamental analysis of investors.
For example, a stock’s price has retraced in a short-term downtrend and is now hovering above its 200 EMA. If the underlying business’ valuations and future prospects are favorable at these price levels, current investors will be unwilling to sell it further and new investors will want to buy into that stock. These dynamics create sustainable upward pressure which results in the stock ‘bouncing’ off its 200 EMA.