Of all the questions I get about trading, this one ranks among the most common…
"Which indicator do you prefer to use the most?"
That’s an easy one: It’s the exponential moving average, aka EMA.
I’m a fan of using the EMA to measure pullbacks away from the main trend. It’s a very simple method that works remarkably well for finding stocks and other markets that are trending — and more importantly, measuring a pullback away from the trend (click here to learn more about the art of mastering pullback trades).
How does it work? Check out this example…
Here, I found a stock that was trending strongly above the 20-day EMA and waited for the stock to trade completely below the 20-day EMA.
I waited a few days for the stock to come back completely above the moving average, but I don’t recommend you wait more than five days for this event to occur.
In other words, once the stock drops completely below the 20-day EMA, you should wait no more than five trading days for the stock to rally above the 20 day EMA.
In this chart, you’ll see the entire process that I just described. The market first rallied above the 20-day EMA then traded below the 20-day EMA and finally within two days traded completely above the 20-day EMA. Check it out…
You Can See The Entire Progression In This Example
MACD. Bollinger bands. 20-Day Exponential Moving Average. You’re not using them right.
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Creating A Complete Trading Method Using 20 Day Exponential Moving Average
Now I’ll show you the correct way to enter this strategy and where to place your stop-loss order.
First, I highly suggest you pick stocks, futures or forex markets going through volatile periods. Most swing trading methods require strong volatility, and this method is no exception.
You can see in this example how Facebook's stock began trading well above the 20-day EMA before moving completely below the average. The stock stayed below the EMA for less than two trading sessions.
Remember, you never want the stock or other market you’re trading to stay below the average for more than five trading days.
Notice How Facebook Trades Completely Below The EMA Less Than Two Trading Sessions
Once the market trades back above the EMA, we want to find a strategic entry point so that we don’t get stopped out randomly due to market noise.
I prefer to place my entry order immediately above the first bar that trades completely back above the EMA.
I place a buy stop order $.025 cents above the high that was achieved the first day the stock trades completely above the EMA.
Although I’m using stocks in this example, the method applies to commodities, futures, and currencies.
If Stop Isn’t Triggered First Day, Cancel Order, Nullify Trade
This is important: Make sure to monitor the market and make sure you cancel your entry stop order if the trade doesn’t fill the first day after you place your stop order.
You want to see strong momentum coming back into the market after the crossover above the EMA occurred. If the market doesn’t move straight up, the odds are the setup is weak — and you may want to look at other stocks or markets.
Where To Place Your Protective Stop Loss Order
You want to place your stop-loss order at a strategic level so that you don’t get stopped out prematurely due to volatility and market noise.
One of the biggest reasons many trades don’t work out is because the stop-loss level isn’t placed at a strategic level. There’s nothing more frustrating than watching your favorite market or stock get stopped out only to see a strong continuation in your direction.
Make sure you place your stop loss order at the moving average price level immediately between the first bar completely below the EMA and the first bar immediately above the EMA. Here’s an example for you to see exactly where the stop-loss level would be.
Place The Stop Loss Level Between The First Bar Below And The First Bar Above The EMA
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Example From The Short Side
Just in case the example above was a bit confusing, I’m going to confuse you even more by showing you the entire sequence from the short side. I’m kidding … this won’t confuse you more … it will actually help a lot.
It’s a very good idea to see how the setup looks visually from the long side as well as the short side. Notice in this example the stock only stayed above the moving average for three trading days.
Avoid the Trade If the Stock Remains Above the Moving Average for Over 5 Days
Remember: The stop loss placement goes at the moving average level between the first bar outside of the moving average and the first bar inside the moving average.
You can see both bars identified in this example…
You Can Clearly See The First Bar On Each Side Of The EMA
Now that you know how to identify the setup and the first bar inside and outside of the moving average, place your stop loss at the moving average level of the area immediately between the two bars.
You can get a good idea from this example exactly where the stop loss level is placed.
This is a buy stop not a stop loss because we’re selling short.
Ready to start trading with the 20-day EMA? With practice, you’ll see how simple it is — and, like me, you can count the EMA among your favorite indicators, too.