Increase your win rate with Exponential Moving Average

Introduction

Increase your trading win rate by utilising the Exponential Moving Average.  Look for the three key factors in the EMAs to support your trade entry setup and increase your probability of a successful trade.

Price action analysis is the most reliable way of analysing the market. Accurately assessing the price trend of an asset plays an important role in helping traders identify the best trading opportunities. The exponential moving averages (EMAs) help in determining the market trend and momentum.

In this article, we will discuss what EMAs are and the three key ways you can use them to identify optimal trading opportunities.

What is the Exponential Moving Average?

The EMA is a type of moving average which measures the trend of an asset’s price over time just like the simple moving average (SMA). However, the EMA assigns more weight to the most recent price points, unlike the SMA, which only averages the price over a particular interval. For this reason, the EMA is more sensitive to price changes than the SMA, which means that it can capture changes in a trend quickly.

The EMA treats the most recent price as being more relevant than historical price. Thus, as you move further back, the weight attached to the price points reduces.

Using the Exponential Moving Average to Support Trade Entry 

The best trading opportunities occur when the markets are trending. Trends provide trading opportunities with a good risk/reward ratio and a high probability of success. 

You can use the EMA to confirm when the market is trending sideways, i.e., when the price is trading in a horizontal channel. In such instances, the price appears to be clustered around the EMA, as shown in the chart below.

You can adjust the EMA period depending on whether you want to trade a longer or shorter period. In this analysis, we are going to use a combination of two EMAs to generate trading signals – a 20-period EMA and a 50-period EMA. 

Here’s the rationale behind this. The 20-period EMA measures the price trend of the past 20 candles while the 50-period EMA measures the trend of the preceding 50 candles. Since the EMA attaches higher weights to the most recent price changes, it means that the 20-period EMA will be responsive to changes in price and thus will be the first one to detect a change in the trend. When the 20-period and the 50-period EMAs are trending in the same direction, it means that the most recent and distant price changes are trending in the same direction. 

Note, the steeper the EMAs slope, the stronger the momentum of the trend.

Supporting the identified signals using the EMA

When you intend on going long, always use your price analysis first to identify your entry, and then use the EMA to support your analysis.  Consider the price analysis first, and then any indicators that support your analysis increase your probability of a successful trade.

Typically, when the market is on an uptrend, both the 20-period and the 50-period EMAs are sloping upwards. 

The EMAs entry confirmation for a long trade occurs when the 20-period EMA crosses and trends above the 50-period EMA. More so, the price of the asset you are trading must be above both the EMAs. This trend confirms that buyers are exerting an upwards pressure on the price. 

In this example below, consider your entry strategy to be an entry on a breakout above the highs of the consolidation zone (break out through resistance).  At the breakout, you can see the price is above the EMA’s, the EMA’s are sloping upward and the 20-period EMA is above the 50-period EMA.  All these factors are supporting your trade entry for an expected price move to the upside.

Confirming potential selling signals using the EMA

When using EMA’s, a short-selling opportunity is confirmed when the 20-period EMA crosses below the 50-period EMA. Furthermore, the price of the asset must be trading below both EMAs. Ensure that there is a clear downtrend formed, with the EMAs sloping downwards.

After the initial crossing of the 20-period EMA below the 50-period EMA, do not rush to sell. Instead, wait for a confirmation that the downtrend is strong enough to push the price lower. Once the price is trending below both EMAs, wait for the pullback. The confirmation for a short position occurs when the price pulls back and consolidates around the EMAs then breaks into a downtrend. This shows that sellers are dominant in the market.

After the pullback, execute the short trade when the price breaks and closes below both EMAs.

Depending on your trading objectives, you can set a static ‘take profit’ level, or you can use a trailing stop loss to mark your trade exits. 

Using EMA to Measure Risk

The price of an asset tends to oscillate around the EMA. That means that the price will always be drawn back to the EMA. With this logic, we can use the EMAs to measure risk. Here’s how.

Let’s take the example of a bullish market. As we’ve noted earlier, in an uptrend, the EMAs are sloping upwards with the price trading above the EMAs. As the price moves up it will move further away from the EMAs. Picture an elastic band between the price and the EMA.  The further away the price moves, the more chance that it will pull back to the EMA.  When the price is a long way from the EMA, there is a higher risk of the price pulling back to the EMA. Avoid opening new positions under this condition as they are high risk trades.

Conclusion

The EMA is primarily used to help identify the trend and momentum of an asset’s price. Make sure to use pullbacks or other entry strategies to identify your trade entry, and use the EMA to confirm your analysis.  Look for the price above the EMA, the short term EMA above the longer term EMA, and the EMA’s sloping up to support a long entry (uptrend). Remember, you can also use the EMA to measure the risk of a price retracement within your trend.

If you want more information on Exponential Moving Averages try this video.

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