Exponential Moving Average (EMA) is one of the best technical indicator used extensively by traders and investors in stock market. Reason being, exponential moving average (EMA) gives more weight-age to the recent price data as compared to Simple Moving Average (SMA).
EMA is very much similar to SMA as it helps traders to measure trend direction of any security. EMA helps in predicting the future trend, Essentially its a trend direction indicator.
EMA gives more accurate recent price action compare to SMA. This is because EMA uses the latest data point and the oldest data point gets the least observation. To understand it better let me give you an example:
In the above data, while calculating the average, we give equal important to every price point. The price on 01 June is equally important, as the price on 05 June. However, when we talk about stock market, this may not always be true. In technical analysis, there is a famous quote and i am quoting “markets discount everything” unquote.
Which means the latest price that you see on 05 June, discounts all the known and unknown information in market. Therefore, the price on 05, is more important than the price on 03, or for that matter 01 June.
Hence, EMA uses weightage to data points based on the ‘newness’ of the data. Therefore the data point on 05 June gets the highest weightage, 03 June gets the next highest weightage, 02 June gets the 3rd highest, so on and so forth.
By doing so, we are giving, the latest data point maximum observation and the oldest data point gets the least observation.