With the ability to objectively calculate and respond better to price movement, the DEMA indicator is surely worth trying. How to use it in a strategy?
Most traders tend to use Moving Average as their best strategy, especially the Simple Moving Average (SMA) and Exponential Moving Average (EMA). There are other types of Moving Average, but they're not as popular as SMA and EMA. Still, there's nothing wrong with trying a different MA if you want to have another insight in your trend analysis. In this case, have you ever heard about DEMA? It literally stands for Double Exponential Moving Average or Double EMA, known for its responsive nature to the price movement. How does it differ from its more popular counterparts?
DEMA was first developed by Patrick Mulloy. In 1994, he introduced the indicator on the Technical Analysis of Stocks and Commodities magazine. He initially built DEMA to research on a Moving Average that is less lagging and more active in finding opportunities.
Later on, DEMA became competitive due to its fast and better response towards certain price movements compared to the traditional MA that was often too late to show entry signals. However, how the DEMA line is generated can be a bit too complex because this tool combines the single and double EMA to produce a new one. Here's the formula:
EMA1 = EMA of the current price
EMA2 = EMA of EMA1
DEMA = (2 x EMA1) - EMA2
3 Best Uses of DEMA
Now that you know DEMA's advantages and how it's calculated, you may wonder about its functions when applied to the chart. Like all Moving Averages, DEMA's primary role is to identify price trends. But in practice, there are two more benefits that you can get from using DEMA.
1. Trend Identification
If you get the basic use of Moving Average as a trend indicator, then understanding DEMA's application for this function would be easy for you. DEMA tends to stay above the price in a downtrend and moves along below the price when the market is in an uptrend. Be careful during a sideways or consolidation phase, because the DEMA line can't provide accurate signals in this condition.
2. Support and Resistance
Support and resistance levels are mostly divided into dynamic and static support/resistance types. In case you didn't know, static support/resistance is the horizontal lines that limit the price movement on certain levels, whereas the dynamic support/resistance is the one that moves along the price movement so it's not fixed on a particular level.
Pivot Point, Fibonacci, and certain key levels are static support and resistance. As for the dynamic support and resistance, Bollinger Bands and Moving Average are some prominent examples. Since the DEMA indicator is a part of the Moving Average family, it can easily show a dynamic support/resistance when applied with a long-term period. Its role automatically changes with price reversals.
3. Finding Entry Signals
You can spot an entry signal by using a DEMA indicator when the price crosses the line. A crossover between two DEMA lines is also a good method to find opportunities from a changing trend. Whichever the strategy, always make sure you keep an eye on multiple crosses within a short period of time since it usually signifies market uncertainty.
How to Trade with DEMA
Despite its simple display, DEMA can be combined with various types of technical analysis to find better and more confirmed trading signals. One of them is the ABC price pattern. Based on the Elliott Wave theory, the ABC pattern is also known as the zigzag pattern. Meanwhile, if you are more familiar with harmonic trading, the ABC wave that we are talking about here can be identified as the AB=CD pattern.
Here are the rules for setting up buy and sell positions using the DEMA indicator and ABC pattern:
Buy Setup
- A descending ABC wave formed during an uptrend.
- The price has broken the upper range of the ABC pattern and closes above it.
- The DEMA 21 crosses the DEMA 50 from below BEFORE the price breaks from the ABC pattern.
- Open buy after the close of the breakout candle.
- Place the Stop Loss below the Low of the breakout candle.
- Take profit when DEMA 21 crosses DEMA 50 from above.
Sell Setup
- A rising ABC wave formed during a downtrend.
- The price breaks the lower range of the ABC pattern and closes below it.
- DEMA 21 crosses DEMA 50 from above BEFORE the ABC break happens.
- Open sell following the close of the breakout candle.
- Place a Stop Loss above the High of the breakout candle.
- Exit position if DEMA 21 moves across DEMA 50 from below.
All in all, the trading strategy with DEMA was developed to earn more opportunities from impulsive movements right after the correction phase. The price is indeed likely to move faster after a breakout because it enters a new impulsive phase. In this case, the DEMA indicator helps to identify changes in the direction of price movements to confirm the breakout signal. This way, you can ride the new trend as well as avoid the risk of a false breakout.