*A more detailed explanation of how I use the 50 EMA with practical trading examples*
I am continuing on from my previous post where I talked about moving averages and explained what they are, how they are calculated and how one might use them in their trading and investing strategies.
In this blog post I am going to go in to more detail about the 50 exponential moving average (EMA) which is the main moving average that I use in my trading strategies. I will show you how I use it for both contributing to the analysis of new trade positions and also how I use it to add to existing positions (scaling in).
I am going to explicitly use the Euro FX currency for all my examples because I have found it to be one of the best currencies for using the 50 EMA accurately. It has provided me with the largest percentage of successful trade entries and I think this is a good example of how all markets react differently and that it is down to you as trader to test what works and what doesn’t to improve your probability of success.
Let’s start by quickly recapping how the 50 EMA is calculated.
50 Exponential Moving Average = A moving average that is calculated using the close price data from the last 50 periods whilst exponentially giving a higher weighting to the price of more recent periods.
The EMA will naturally react quicker to price movements because of this weighting and therefore it is favoured my traders as an indicator. Through my years of backtesting and trading I have found it to work better than the simple moving average (MA).
The chart above shows a lower timeframe chart for the price of US Oil in USD. As you can see, price often reacts with the 50 EMA sometimes on multiple occasions within the same trading day. This means there are multiple opportunities to use it in your trading strategy to produce trade setups.
How do I use the 50 Exponential Moving Average?
Firstly, it is important to understand that I don’t just use the 50 EMA on its own to decide when and where I am going to enter a trade position. It is one of the many analysis “tools” that I use within my multiple trading strategies.
The main timeframe I use the 50 EMA is on the 1 hour timeframe. This therefore means that the 50 periods the calculator uses to calculate the EMA is the last 50 hours of trading. If you have read my previous blog posts you will know I use the 1hr timeframe chart as my lower timeframe for more accurate trade entries and the 50 EMA assists with finding key price areas for my position entries.
Let’s look at an example of a trade where the 50 EMA combined with a few other tools and basic knowledge, lead to a reasonably accurate short position entry.
The chart above shows a very simple short trade entry that incorporates the 50 EMA in to the analysis and uses it to provide a highly accurate entry with a final return of 4.25:1 reward:risk ratio. I have marked on some other basic points to the analysis including the initial break of the bullish trendline and 1hr 50 EMA. This is a good example of a basic method of trend reversal trading using price action (the highs and lows being made) and the 50 EMA to deterring the directional bias and going with it.
When price broke through the trendline and 50 EMA, it is safe to assume the bullish trend is now turning bearish. By waiting for the next rejection of the 1hr 50 EMA from the underside it can be used as a good entry point for a new short position. The 50 EMA has gone from being a dynamic support for price on the previous bullish trend, to now being a potential resistance for the bearish trend.
I purposely haven’t shown some other points to the analysis because that is not what this blog post is about. However, if you are a regular reader of my blog then you may be able to piece together the other parts of “the puzzle”. If not, then I recommend you read my other trading education blog posts by clicking on the link below.
Next I will show you now you can use the 50 EMA to assist you with scaling in to an existing trade and add multiple positions to exponentially increase your returns.
The chart above shows 4 consecutive short positions entered on the same, EURJPY, FX currency pair. Each new position incorporates the 1hr 50 EMA into its analysis along with a few other key analysis points to provide a reasonably accurate entry and great reward:risk ratio.
As you can see, as the trade goes on, the 1hr 50 EMA continued to act as a significant dynamic resistance and therefore price remained below the 50 EMA and maintained its bearish trend. This trend is what I intended to capitalise on in this example and by only entering short positions at the 1hr 50 EMA, I was trading with the trend and increasing my probability of success.
I won’t go in to too much detail about my risk management on these sorts of positions but you may be able to figure this out for yourselves by using the details from the chart. By using a standard sized stop loss and entering at the 1hr 50 EMA, these 4 positions produced a gross total return of over 16R across a period of 10 trading days.
More importantly, each new short position was only opened once the previous position was made net risk free (exposure removed) in order to maintain a consistent 1R risk value across all open positions.
In my opinion, this is one of the most important rules in regards to scaling in on trades and entering multiple positions. If you do not do this, you may find yourself over exposed and subject to greater losses than you may have wanted.
Day trading using the 50 EMA.
As I mentioned in the previous blog post about moving averages, I also use the 50 EMA in my day trading strategy. I combine it with the 200 period EMA to monitor their alignment against each other in order to determine the current market trend.
The chart below shows an example of my day trading chart setup.
With both the 50 EMA and the 200 EMA on the chart, the alignment of these 2 EMA’s is quickly and easily visible and therefore good to use as a trend direction indicator. With the short term EMA (50) below the longer term EMA (200) it is okay to assume the current trend is bearish and therefore the probability of short trades being successful is greater.
With this bearish trend alignment shown on the chart above, you can see that each consecutive trading day is bearish with price closing lower than open.
You can therefore use this to your advantage and strategically open short trade positions at various points throughout the day to capitalise on the next bearish move.
Limitations of using the 50 EMA.
The probability of the 50 EMA providing accurate support/resistance for price is most high when the market in question is trending. This I due to the nature in which the EMA is calculated. If prices are rising then the 50 EMA will increase and the opposite is true for decreasing prices. If the market price of the instrument you are trading begins to become range bound then the 50 EMA will lose its effectiveness and begin to flatten out. This means there is a greater chance of price breaking through the EMA.
The chart below shows and example of this.
It is not uncommon to see price break through the 50 EMA multiple times from both directions in a tight range bound scenario. It is down to you as a trader to learn the different phases of the markets and spot when markets are becoming range bound to avoid unnecessary losses.
Another limitation of using the 50 EMA is that it should not be treated as a 100% accurate entry tool. Price often spikes through the 50 EMA when it is testing it’s resistance/support ability before it then holds and the trend continues. It is therefore prudent to have a suitable sized stop loss in order to withstand the volatility of price at these times.
I apologise for this post being slightly delayed as it was due out earlier this week. I hope it brings some value to your trading or at least sparks your interest in potentially using EMA’s within your strategies.
As with all things, it is important to research these methods for yourselves and fully understand how they work before using them in a live trading environment.
Thanks for reading and please don’t forget to LIKE, SHARE and FOLLOW my blog to stay up to date with the latests posts and market analysis.
DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.