A moving average is a simple but powerful tool that can help you identify the trend direction, support and resistance levels, and momentum of a security. It is calculated by taking the average price of a security over a specified number of periods, such as days, weeks or months. By doing so, it smooths out the random fluctuations and noise in the price data and reveals the underlying trend.
There are different types of moving averages that can be used for technical analysis, each with its own advantages and disadvantages. In this blog post, we discuss the Double Exponential Moving Average.
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Introduction
DEMA, which stands for Double Exponential Moving Average, is a technical indicator used in technical analysis to smooth out price data and help identify trends. DEMA is a type of moving average that gives more weight to recent price data, compared to traditional moving averages, by applying two exponential moving averages to price data.
Patrick Mulloy is credited with creating the Double Exponential Moving Average (DEMA), which was first presented in the February 1994 edition of “Technical Analysis of Stocks and Commodities” magazine. Mulloy created the DEMA to provide traders with a smoother and more responsive moving average than the traditional simple and exponential moving averages. The DEMA has since become a popular technical indicator used by traders around the world.
To calculate the DEMA, you first calculate an EMA with a given period, and then calculate a second EMA with the same period applied to the first EMA. The result is a smoother moving average that responds more quickly to changes in price compared to a simple or exponential moving average.
DEMA is used in technical analysis as a trend-following indicator, and traders often use it to confirm price trends or to help identify potential trend reversals. When the price is above the DEMA, it is considered bullish, and when the price is below the DEMA, it is considered bearish.
Traders can also use DEMA crossovers as trading signals. For example, when the DEMA crosses above the price, it may signal a buy opportunity, and when the DEMA crosses below the price, it may signal a sell opportunity.
It’s important to note that like any technical indicator, DEMA has its limitations and should not be relied on solely for making trading decisions. It should be used in conjunction with other technical indicators and fundamental analysis for a well-rounded approach to trading.
Computing the Double Exponential Moving Average
To determine the Double Exponential Moving Average (DEMA), the initial step is to compute the Exponential Moving Average (EMA) for a designated timeframe. Next, a second EMA is calculated with the same period applied to the first EMA. Finally, the DEMA is derived by calculating the difference between the two EMAs and adding it to the current value of the second EMA. This result is a smoother moving average that responds more quickly to changes in price compared to a simple or exponential moving average.
To calculate the Double Exponential Moving Average (DEMA), you will need to perform the following steps:
Calculate the first Exponential Moving Average (EMA) with a given period (n) using the closing price (CP):
EMA1 = EMA(CP, n)
Calculate the second EMA with the same period (n) applied to the first EMA calculated in step 1:
EMA2 = EMA(EMA1, n)
Calculate the DEMA by multiplying the first EMA by two and subtracting the second EMA from the result:
DEMA = (2 * EMA1) - EMA2
The formula for the DEMA is:
DEMA = (2 * EMA(CP, n)) - EMA(EMA(CP, n), n)
Where:
CP = Closing price
n = Number of periods used for the EMA calculation
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How to use the Double Exponential Moving Average in trading?
To make the most of the Double Exponential Moving Average (DEMA) in trading, it’s important to integrate it into a well-rounded trading strategy. Here are some practical tips to help traders effectively use the DEMA in their trades:
Determine the appropriate period
The first step is to decide on the appropriate period for the DEMA based on the trader’s preferred time frame and the market being traded. While shorter periods are more responsive to price changes, they can also result in more false signals. On the other hand, longer periods provide more reliable signals but may not be as responsive.
Use the DEMA in conjunction with other indicators
The DEMA should be used in conjunction with other indicators such as support and resistance levels, trend lines, and other moving averages. This helps to confirm potential trades and avoid taking trades against the overall trend.
Look for crossovers with price
One of the most common ways to use the DEMA is to look for crossovers with price. When the price crosses above the DEMA, it may signal a buy opportunity, and when the price crosses below the DEMA, it may signal a sell opportunity. Traders can use these crossovers to enter and exit trades based on changes in the trend.
Consider the trend direction
The DEMA can be used to confirm the direction of the trend. When the price is above the DEMA, it is considered bullish, and when the price is below the DEMA, it is considered bearish. Traders can use this information to help determine the direction of their trades.
Use the DEMA as a filter
The DEMA can be used as a filter for other trading signals. For instance, traders may only take long trades when the price is above the DEMA, or only take short trades when the price is below the DEMA. This approach can help traders avoid taking trades against the overall trend and potentially increase their chances of success.
Practice proper risk management
Proper risk management is crucial when using the DEMA in trading. This includes setting stop-loss orders to limit potential losses and using position sizing to manage risk and avoid overexposure to any one trade.
Backtest and refine the strategy
It’s important to backtest the DEMA-based trading strategy using historical data to evaluate its effectiveness and make necessary adjustments. This can help traders identify any weaknesses in their strategy and refine it over time for better results.
Be aware of market conditions
The effectiveness of the DEMA can vary depending on market conditions such as volatility and liquidity. In highly volatile markets, the DEMA may generate more false signals, while in less volatile markets, it may be slower to respond to price changes. Traders should be aware of the current market conditions and adjust their DEMA-based strategy accordingly.
Remember that the DEMA is just one tool among many in a trader’s arsenal, and should not be relied on solely for making trading decisions. It should be used in conjunction with other technical indicators and fundamental analysis for a well-rounded approach to trading.
Patrick Mulloy on the Double Exponential Moving Average
Patrick Mulloy created the Double Exponential Moving Average (DEMA) as a means of offering traders a superior and more nuanced moving average compared to the conventional simple and exponential moving averages. Mulloy designed the DEMA to be used as a trend-following indicator, enabling traders to identify potential trend changes or confirm existing trends.
Traders can generate trading signals using the DEMA in various ways. One popular technique is to observe crossovers between the DEMA and the price. When the price crosses above the DEMA, it may indicate a buying opportunity, and when the price crosses below the DEMA, it may indicate a selling opportunity. This crossover approach can help traders enter and exit trades based on changes in the trend.
Mulloy wanted traders to use the DEMA to filter other trading signals. For example, traders may only take long trades when the price is above the DEMA or only take short trades when the price is below the DEMA. This strategy can assist traders in avoiding trades against the overall trend and potentially improve their chances of success.
It’s essential to note that like any technical indicator, the DEMA has its limitations and should not be relied on solely for making trading decisions. Traders should use the DEMA in conjunction with other technical indicators and fundamental analysis for a comprehensive trading approach.
Advantages & Limitations of the Double Exponential Moving Average
Here are some advantages and limitations of using the Double Exponential Moving Average (DEMA) in trading:
Advantages
- Smoother and more responsive: The Double Exponential Moving Average (DEMA) is smoother and more responsive compared to traditional simple and exponential moving averages. This makes it a valuable tool for identifying potential trend changes or confirming existing trends in trading.
- Reduced lag: The DEMA has reduced lag compared to other moving averages, making it more suitable for short-term trading strategies.
- Customizable: The DEMA can be tailored to the specific market being traded and the trader’s preferred time frame, allowing for more flexibility in trading strategies.
- Complements other indicators: The DEMA can be used in combination with other technical indicators to confirm potential trades, making it a valuable addition to a trader’s toolkit.
Limitations
- Generates false signals: The DEMA, like any technical indicator, can produce false signals in certain market conditions. If relied upon too heavily, it could result in losses.
- Not a standalone indicator: The DEMA should not be used as a standalone indicator. It should be used in conjunction with other technical indicators and fundamental analysis for a comprehensive approach to trading.
- Subjective interpretation: The interpretation of the DEMA can be subjective and may vary between traders, potentially leading to inconsistent trading decisions.
- Historical data dependence: As with all technical indicators, the DEMA relies on historical data, and past performance is not always an indicator of future results. Traders should always practice proper risk management and avoid risking more than they can afford to lose.
The DEMA is a widely-used technical indicator that can be a powerful tool for traders. Compared to traditional moving averages, the DEMA offers a smoother and more responsive signal, making it ideal for identifying potential trend changes or confirming existing trends. It can be used in various trading strategies, including generating trading signals and filtering other indicators.
It’s crucial to bear in mind that even the DEMA, a widely used technical indicator, has its limitations. Traders should complement it with other indicators and fundamental analysis to make informed trading decisions. It’s important to remember that past performance doesn’t guarantee future results, so traders should prioritize proper risk management and avoid risking more than they can afford to lose.
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