Fox Trader: Double Exponential Moving Averages Explained

Traders have relied on moving averages to help pinpoint high probability trading entry points and profitable exits for many years. A well-known problem with moving averages, however, is the serious lag that is present in most types of moving averages. The double exponential moving average (DEMA) provides a solution by calculating a faster averaging methodology.
Tutorial: Moving Averages

History of the Double Exponential Moving AverageIn technical analysis, the term moving average refers to an average of price for a particular trading instrument over a specified time period. For example, a 10-day moving average calculates the average price of a specific instrument over the past 10 ten days; a 200-day moving average calculates the average price of the last 200 days. Each day, the look-back period advances to base calculations on the last X number of days. A moving average appears as a smooth, curving line that provides a visual representation of the longer-term trend of an instrument. Faster moving averages, with shorter look-back periods, are choppier; slower moving averages, with longer look-back periods, are smoother. Because a moving average is a backward looking indicator, it is lagging. The double exponential moving average (DEMA), shown in Figure 1, was developed by Patrick Mulloy in an attempt to reduce the amount of lag time found in traditional moving averages. It was first introduced in the February 1994, Technical Analysis of Stocks & Commodities magazine in Mulloy's article "Smoothing Data with Faster Moving Averages". (For a primer on technical analysis, take a look at our Technical Analysis Tutorial.)

Figure 1: This one-minute chart of the e-mini Russell 2000 futures contract shows two different double exponential moving averages; a 55-period appears in blue, a 21-period in pink.

Source: Tradestation

Calculating a DEMAAs Mulloy explains in his original article, "the DEMA is not just a double EMA with twice the lag time of a single EMA, but is a composite implementation of single and double EMAs producing another EMA with less lag than either of the original two."
In other words, the DEMA is not simply two EMAs combined, or a moving average of a moving average, but is a calculation of both single and double EMAs.
Nearly all trading analysis platforms have the DEMA included as an indicator that can be added to charts. Therefore, traders can use the DEMA without knowing the math behind the calculations and without having to write or input any code.
Comparing the DEMA with Traditional Moving AveragesMoving averages are one of the most popular methods of technical analysis. Many traders use them to spot trend reversals, especially in a moving average crossover, where two moving averages of different lengths are placed on a chart. Points where the moving averages cross can signify buying or selling opportunities.
The DEMA can help traders spot reversals sooner because it is faster to respond to changes in market activity. Figure 2 shows an example of the e-mini Russell 2000 futures contract. This one minute chart has four moving averages applied:

21-period DEMA (pink)
55-period DEMA (dark blue)
21-period MA (light blue)
55-period MA (light green)

Figure 2: This one-minute chart of the e-mini Russell 2000 futures contract illustrates the faster response time of the DEMA when used in a crossover. Notice how the DEMA crossover in both instances appears significantly sooner than the MA crossovers.

Source: Tradestation

The first DEMA crossover appears at 12:29 and the next bar opens at a price of $663.20. The MA crossover, on the other hand, forms at 12:34 and the next bar's opening price is at $660.50. In the next set of crossovers, the DEMA crossover appears at 1:33 and the next bar opens at $658. The MA, in contrast, forms at 1:43, with the next bar opening at $662.90. In each instance, the DEMA crossover provides an advantage in getting into the trend earlier than the MA crossover. (For more insight, read the Moving Averages Tutorial.)
Trading With a DEMAThe above moving average crossover examples illustrate the effectiveness of using the faster double exponential moving average. In addition to using the DEMA as a standalone indicator or in a crossover setup, the DEMA can be used in a variety of indicators where the logic is based on a moving average. Technical analysis tools such as Bollinger bands, moving average convergence/divergence (MACD) and triple exponential moving average (TRIX) are based on moving average types and can be modified to incorporate a DEMA in place of other more traditional types of moving averages.
Substituting the DEMA can help traders spot different buying and selling opportunities that are ahead of those provided by the MAs or EMAs traditionally used in these indicators. Of course getting into a trend sooner rather than later typically leads to higher profits. Figure 2 illustrates this principle - if we were to use the crossovers as buy and sell signals, we would enter the trades significantly earlier when using the DEMA crossover as opposed to the MA crossover.
Bottom LineTraders and investors have long used moving averages in their market analysis. Moving averages are a widely used technical analysis tool that provides a means of quickly viewing and interpreting the longer term trend of a given trading instrument. Since moving averages by their very nature are lagging indicators, it is helpful to tweak the moving average in order to calculate a quicker, more responsive indicator. The double exponential moving average provides traders and investors a view of the longer term trend, with the added advantage of being a faster moving average with less lag time. (For related reading, take a look at Moving Average MACD Combo and Simple Vs. Exponential Moving Averages.)

Fox Trader

Wednesday, October 27, 2010

Double Exponential Moving Averages Explained

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