Exponential Moving Averages in Options Trading

Moving averages are basic tools for analyzing price movements in the stock market. By smoothing out the usual up and down fluctuation in the market, a moving average provides a clearer view of emerging trends. A drawback of focusing too heavily on a moving average is that an investor or trader can miss recent price action that is important. To avoid this dilemma on approach it is to use an exponential moving average or EMA which gives more “weight” to recent price action while still providing the “smoothing out” value of a standard moving average. As with all other aspects of trading, it is important to exercise discipline when using exponential moving averages in options trading or when trading stocks directly.

Best EMA When Day Trading

Just like when a trader uses a standard moving average, when they are interested in trading over shorter time spans they will need to use an EMA that looks at a shorter time span. For day trading, an EMA of anywhere from eight to twenty days is common while fifty, one hundred, and two-hundred day exponential moving averages are more appropriate for swing trading over days and weeks or investing with the same time spans in mind. When a trader is concerned with very quick up and down movements in the market, they will need to err on short time frame side of this tool to get the maximum value.

EMA Crossovers for Day Trading Versus Swing Trading

When using moving averages or exponential moving averages it is common to use two of them. When that is the case there are many times when the moving average or EMA with the shorter time horizon crosses over the one with the longer time horizon. When this happens with the 50-day and 100-day moving average it is a golden cross when the 50-day crosses from below and it is called a death cross when it crosses from above. These crossovers commonly signal new market trends whereas when the shorter EMA hits the longer and “rebounds,” it typically does not. Crossovers are useful for all time spans in trading and when a trader is working with shorter term trades they will want a pair of shorter term EMAs or standard moving averages, typically in the ten to twenty day range for day trading.

Using EMAs to Trade Stocks

Because stock price falling below an EMA is commonly a selling opportunity and a stock price rising above a moving average is often a buying opportunity one can simply follow a stock as it moves toward or away from a moving average and trade accordingly. At Top Gun Options we commonly use moving averages to analyze the market but we also keep an eye on the larger picture as well. As such we apply discipline to our trades and because we are trading options, we hedge every single trade to limit our downside risk. We follow our checklist for placing trades, always remaining aware of why we entered a trade, what we expected, and our exit strategy.

No Guarantees with Any Technical Indicator

Moving averages and exponential moving averages are useful tools when trading stocks. Nevertheless, it is wise to use at least one other technical indicator if you are relying solely on technical analysis to choose, enter, manage, and exit your trades. There are times when any technical indicator will lead you astray when trading. These are times when the market is following the sentiment of the herd and that sentiment is wrong about underlying factors. We saw this clearly at the start of the Covid crash when “smart money” said to buy the dip and we went long volatility, held cash, and bought puts on the S&P 500. Likewise, when the Fed stepped in and dumped money into the economy and the market, we knew that you cannot fight the Fed and reversed course even while many “smart money” folks finally said it was time to sell! The point is that while an EMA is a useful tool it should be only part of a successful options trader's toolbox.