Exponential Moving Average Trading Strategy Revealed
BY Chris Andreou
|February 16, 2022The exponential moving average is one of the most popular and versatile indicators used in trading. It can be used to determine trends, dynamic support and resistance areas and confirm entry and exit signals.
The reason why an exponential moving average strategy is a very popular among beginners is because of its simplicity. Do you want to start trading but you’re not sure which strategy to use, or even how to create one and place your trades? Are you interested to learn more about a simple strategy using moving averages? Then this article is for you.
In this article, I’ll show you how to create an Exponential Moving Average (EMA) trading strategy using three EMAs in MT4 or MT5. You will learn how to use them to identify trends, dynamic support and resistance areas, and what a good trading strategy could look like.
Further to that, you can adapt this exponential moving average strategy and combine it with other indicators to make it your own.
So without any further delay, let’s get started.
Register your trading account and download the trading platform so you can follow along. The information in this article is speculative in nature and for your educational purposes only. Please read the full disclaimer at the end.
The exponential moving average strategy
The Exponential Moving Average (EMA) is one of the most basic indicators found on practically any trading platform. It’s also one of the easiest to calculate, explain and interpret.
You can add an exponential moving average on your MT4 or MT5 trading platform, and the indicator will overlay on the chart.
I know there might be a lot of big words in the paragraphs above for some of you, so let me slow down and explain things.
What is an exponential moving average?
The main purpose of an exponential moving average is to smooth out price data so that a trend can be detected. It works by calculating the average price over a given period of time.
For example, the closing prices over the last 20 periods could be added together and dividing the total by 20 would give us a simple average price. As the market action unfolds, new prices will be added to the calculation while older ones will be removed. This will provide a simple average of the last 20 time intervals that moves with the price.
The difference between the simple moving average and the exponential moving average is, the latter gives more weight to recent data. Making it more sensitive and adaptive to what is currently happening with price.
From the image above, you can see the slight difference between the two moving averages. The one on the left is the exponential moving average. It hugs the price closer than the one on the right, which is the simple moving average. Both of these are calculating the average price of the last 20 time intervals, and plotting it (orange line) at the far leading edge.
Why use exponential moving averages?
The exponential moving average (EMA) is a weighted average price of the last “X” number of time intervals. The EMA reacts more significantly to recent price changes and places more significance to it than the simple moving average (SMA) does.
Moving averages are used to smooth out price data to help identify price trends and potential changes in trends. They can also act as dynamic support and resistance areas and help traders find entry and exit points for their trades. Traders can use multiple moving averages together, for different time intervals, to identify shorter and longer term price trends.
Next, I’m going to show you how to find and add the exponential moving average to your charts.
How to find the exponential moving average in MT4 or MT5
To add the exponential moving average to your chart, open the MT4 or MT5 trading platform. Then navigate to the insert menu at the top, hover over the indicators > trend menu option and select moving average.
Adding the exponential moving average to your charts
A pop up window will appear with some options so you can configure the moving average indicator.
From the top down, the most relevant options for this exponential moving average strategy are;
Period: This allows you to select the number of periods the average price will be calculated for. For example, if you select 20 and view the daily time frame, the average price will be calculated over the last 20 days. If you select 10 and view the hourly time frame, the average price will be calculated over the last 10 hours.
Method: Choose this option to select the calculation method of the moving average. The options include, simple, exponential, smoothed, and linear weighted. You can experiment with the different options but this is an exponential moving average trading system, so the relevant method is exponential.
Style: From here, you can change the colour, thickness and line type for the moving average. It is particularly useful when using multiple moving averages to calculate the average prices over different time intervals. This is what this exponential moving average trading strategy will be doing.
Let’s get in to that now.
How to use the exponential moving average strategy to trade
The theory of this exponential moving average trading strategy is simple. To identify what the longer, medium and shorter term price trends are and trade in whatever direction they are all pointing towards.
It is a trend following strategy with simple entry and exit signals and allows profitable trades to run.
How does the strategy work?
First, open three charts (Daily, 4H and 1H) of your favourite currency pair. For this example, I will be using the GBPUSD. You can select any three time frames that you like but the Daily, 4H and 1H charts will provide sufficient trading signals. Whatever three timeframes you choose, use the highest time frame to determine the relative longer term trend. The other two charts will be used to determine the medium and short term trends.
Add a 50 period EMA to the daily time frame, a 20 period EMA to the 4H time frame and a 12 period EMA to the 1H time frame. It should look something like this;
When the exponential moving average on the daily time frame is sloping up, or if price is closing above it, you should only consider taking buy opportunities. The inverse is true if the EMA is sloping down or if price is closing below it. You should only consider taking sell opportunities.
Now that you have determined your directional bias, you can go to the next step. To determine whether the medium term price trend is in agreement or in alignment with the longer term one.
As you can see from the image above, price is above the EMA(50) on the daily time frame. But, it is below the EMA(20) on the 4H time frame so, they are not yet aligned. This is a mixed signal, either the medium term trend on the 4H chart has to change or the longer term trend on the daily does. When the trend on these two timeframes is aligned, you can move to the next step.
The next step in this exponential moving average strategy is to look for an entry signal when the short term trend on the 1H time frame is aligned with the medium and longer term ones.
We will get to this is just a moment, but let’s quickly summarise these conditions.
The rules of the exponential moving average trading strategy
Look for buy opportunities when;
- Price closes above EMA(50) on the daily time frame.
- And when price closes above EMA(20) on the 4H time frame.
- And when price closes above EMA(12) on the 1H time frame.
Look for sell opportunities when;
- Price closes below EMA(50) on the daily time frame.
- And when price closes below EMA(20) on the 4H time frame.
- And when price closes below EMA(12) on the 1H time frame.
The image below shows the market condition you are looking for before getting ready to execute a trade in either direction. The candlesticks for all three intervals should close above or below all three EMA’s on all three time frames. In this example, you could proceed to look for the signal to execute a sell, only if the price closes below the EMA on all three time frames.
The Buy and sell signals
There are two signals you can look for to execute either a buy or a sell. The first one is a simple break of a support or resistance area. In the below example, price breaks support and follows through and trades lower. When this happens, the exponential moving average strategy anticipates the resumption of the medium and longer term trends.
The buy signal is just the inverse of this, when price breaks a resistance area, the strategy anticipates the resumption of the bullish trend from the higher time frames.
Another signal to buy or sell could be when the exponential moving averages act as support or resistance areas. As long as the EMA’s and price are aligned on all three time frames, price could bounce off of them and resume the current trend.
The exit signals
To exit the open trade in case of a winning trade, you can either target a recent resistance area for buys or support areas for sells. Look at the historical price action for recent swing highs or lows on all three time frames.
Alternatively, you can place a stop loss and trail it below the recent highs and lows and let the trade run. The trailing stop loss will trigger the closure of the trade when the momentum slows or shifts in the opposite direction.
In case the trade doesn’t work out, you should exit the trade when you think the conditions for the buy or sell are no longer valid. For example, you could place a stop loss at the recent swing highs or lows.
Money and risk management
This is up to you; however, it is prudent to risk a small percentage of your account balance on any single trade idea. It will take some practice and time to get used to trading this system and it is important to remember that all trading methods will have losing trades.
Strategy limitations and risks
Therefore, there will be some limitations and risks when using this exponential moving average trading strategy. These can include false signals, since the price is being averaged and much of the detail is being smoothed out.
Also, the moving average indicator is a lagging indicator, which means that price must move first before the indicator can make its calculation. Moving averages can never predict future price movements, only anticipate them and confirm the existing tend.
Furthermore, moving averages can work well when market conditions are in a trending phase but fail all too often when price is range bound. The entry and exit signals generated by the EMA’s may occur late and chop around the EMA resulting in lower profits and even losses.
It is best to apply additional analysis tools to help you make better informed trading decisions.
Conclusion
The exponential moving average is a popular technical indicator used by many traders. It helps monitor price movements and assesses price momentum in the market. EMA’s are lagging indicators based on historical prices, but it uses a multiplier to give greater weight to more recent price data in an attempt to make it more sensitive to price changes.
An exponential moving average strategy has been outlined above, using multiple time frames to help you form a directional bias. When the short, medium and longer term trends are aligned, you can look for buying or selling opportunities.
It will take some observation and practice to learn how it works as well as the limitations and risks of using it. You can practice trading on a demo account and adapt the strategy to make it your own. Download the MT4 or MT5 trading platform to practice risk free with up to $50,000 in virtual funds.
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