If I Had to Choose One Indicator for Technical Analysis, It Would Be This
I participated in a trading webinar this past weekend where I demonstrated a few strategies to about 1,000 traders. The question I got asked the most over and over by at least 20 participants was to provide my favorite indicator for trading technical analysis strategies.
My explanation was rather simple; the best indicator is the one that fits the type of market environment that you are currently trading.
Although my answer was accurate and correct, I could tell that my answer was too vague and didn’t satisfy the curiosity of most traders. After the seminar ended I was asked one last time a slightly different question. The question was “if you had to choose only one technical analysis indicator, what would it be?
The Moving Average Indicator
My answer was quick and fast, it would be the 20 day exponential moving average. The exponential moving average is a variation of a simple moving average.
Before computers were widely used for market analysis, traders relied on simple moving average indicators because they were easy and simple to calculate.
To calculate a 10-day simple moving average, simply add the closing prices of the last 10 days and divide by 10. The 20-day moving average is calculated by adding the closing prices over a 20-day period and divide by 20, and so on.
As traders began using computers in the early seventies, they wanted to find ways to make improvement to the moving average, more specifically they wanted to find a way to create less lag between the market they were analyzing and the indicator.
The simple moving average was just not fast enough to react to volatile market swings. Traders wanted an indicator that was similar to a simple moving average but would put more weight on recent price action and less on past price action.
You can see in this example how the simple moving average reacts much slower to price action than the exponential moving average. This is the primary reason why most short term traders and day traders use the exponential moving average instead of the simple one.
Notice How The Red Line Is More Dynamic Than The Green Line
Take a look at another example of how the exponential moving average is quicker to react when trading technical analysis trends. In this you can see how much faster the exponential moving average reacts to the stock turning back up. The simple moving average barely moves while the stock is gaining substantial momentum upwards.
The Green Line Barely Moves While Stock Gains Substantial Momentum Upwards
The Best Way To Utilize The Exponential Moving Average
Since the exponential moving average is very dynamic and responds well to recent price changes, I tend to use it to trade pullback or retracement strategies.
The first thing you need to do is to adjust the exponential moving average to 20 days. The 20 day is a good starting point for most volatile stocks, futures and currency markets. If you are day trading, use 20 bars instead of 20 days.
After you adjust the settings you want to find a stock or other market that’s trading substantially above the 20 day exponential moving average. The further the price is away from the average the better. You can see in this example how far the stock is trading above the moving average. This is a great filter for finding stocks or other markets that are trending strongly.
You Want to Find Stocks or Other Markets That Are Rising Sharply Away From The EMA
The next step is to monitor the stock or market you are trading and wait for the market to trade completely below the 20 day EMA. This example shows you exactly what I mean. You want to make sure that the high is not touching the EMA and is trading completely below it.
The Stock Rallied and Within A Few Days Drops Completely Below the EMA
The next step after the stock or other market you are trading drops completely below the 20 day EMA is to wait for the market to trade once again completely above the 20 Day EMA. You can see how the stock only dropped for a few days prior to resuming the strong trend, this is a good sign. If the stock was to stay below the average for more than one week I would probably be a bit concerned about continued momentum.
The Move Below the Moving Average Was Short Lived
Here is how the entire pattern looks like on one continues chart. You can get a good feel for how the 20 day EMA filters strong trending markets and more importantly, how it identifies pullbacks away from the main trend.
You Can See the Entire Process On This Chart
During the last two days I presented basic techniques for beginners who want to learn technical analysis trading strategies. More specifically I focused on my favorite indicator the Exponential Moving Average or EMA for short. The first day I covered the basics of the indicator and demonstrated the difference between the Simple Moving Average (SMA) and the (EMA).
The EMA proved much more responsive to short term price fluctuations and demonstrated better response to momentum and volatility. You can see by looking at this chart how much more responsive the EMA can be compared to the SMA.
Please keep in mind that although I’m demonstrating this method with stocks, it applies to futures, commodities and currency markets just as well. And if you are a day trader, you can change the bars from daily to 5 minute and apply this method to E-mini Futures Contracts as well.
Notice How Much Faster the EMA Responds To Volatility
The Set Up
After demonstrating the effectiveness of the EMA compared to the SMA I adjusted the EMA to 20 look back twenty days. This gives me a good time frame and makes the EMA more responsive to short term market swings. You can experiment with different settings but I suggest you start off with the 20 day.
After adjusting the EMA to 20 days I demonstrated the precise entry method that we will use to enter the market using the 20 day EMA. The basic principle is to use the EMA to measure pullbacks away from the trend. We simply find a stock that’s trending strongly above the EMA, the more distance between the stock and the EMA the better the trend.
Look For Markets That Are Trending Strongly Above The EMA
The next step is to wait for the stock to trade completely below the EMA for 5 days or less. If the stock trades below the EMA for more than 5 trading days the trade is nullified and if the stock trades completely above the EMA within the 5 trading days you would enter a buy stop order above the first bar that trades completely above the EMA.
The Stock Only Traded One Day Below The EMA – Remember 5 Days Max
Placing Protective Stop Loss
The final step we covered yesterday was where to place your stop loss level so that random price fluctuations or market noise doesn’t cause you to be stopped out prematurely. My advice is to place your stop at the EMA level immediately between the last bar that traded completely below the EMA and the first bar that traded completely above the EMA. This may sound a bit confusing so take a look at this example for clarification.
Place Your Stop Loss At The Exact EMA Level Between The Two Bars
Where to Place Your Profit Target
The final step is to strategically place your profit target and that’s something we will cover in today’s tutorial. You want to make sure and place your profit target at a level that provides you with a solid risk to reward level. Most professional traders use a profit to risk ratio of two to four. This means for every dollar you risk you should profit anywhere from two to four dollars.
This particular method is based on short term price momentum and volatility, therefore using a profit target that’s designed to keep me in the market for a long time will not work with this type of strategy. A good tip is to always plan your exits based on the characteristics of your entry method. I use a simple two to one risk level with this strategy. I want to see very strong momentum coming into the market as quickly as possible after I enter my order.
I simply measure the distance between my entry price and the stop loss level and multiply that number by two. I then add that amount to my entry price and that becomes my profit target for the trade. This ratio offers me a reasonable risk to reward ratio and provides me with an opportunity to take quick profits from the increase in volatility before the momentum dries up once again.
In this particular example the distance between my entry price and my stop loss level was approximately $2.25 cents. I would multiply that number by two and add that amount to my entry price, which in this particular case was $28.60. I then add $28.60 to $4.50 and my profit target in this particular case would be $33.10.
Always Calculate Your Risk Level Before You Enter the Trade
In this final example you can see exactly where the entry and the protective stop loss level are placed. Since we are selling short we would subtract our risk level from our entry and that would provide us with our profit target.
Subtract Your Risk Level from Your Entry Price
In this particular case the risk level on the trade equals $3.00. We would multiply that number twice and subtract it from our entry price. Since our entry was at $158.00 and our risk level was $3.00 we would subtract $6.00 from our entry price and that would provide us with a profit target level of $152.00 even
Profit Targets Are Quick With Pure Momentum Strategies
Things to Keep in Mind
Always remember that pure momentum strategies that are based on volatility have lower profit to loss ratio than other technical trading methods.
Also remember that the 20 bar EMA can be adapted to any market and time frame. The only market I don’t recommend you trade using this method is options.
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