Many traders are quite familiar with the simple moving average (SMA) and the normal exponential moving average (EMA), but few are acquainted with the double EMA because it is less popular. However, the double EMA (DEMA) is a faster version of both the SMA and the standard EMA as it was built to eliminate the lag time associated with most moving averages. The DEMA is used in the same way as the SMA and the EMA, with the main advantage being that it can identify trend changes much faster. Let’s look at all the different ways in which you can use the DEMA to trade stocks.
A bullish crossover occurs when the price crosses above the DEMA line, indicating the start of a bullish trend. Stock traders can use this crossover signal to place long trades in the hope of to capitalising on the bullish trend that is likely to follow. However, it is important to keep in mind that nothing in the markets is guaranteed and that the expected bullish move may not play out in some cases, leading to a losing trade. In cases where a bullish trend follows such a crossover, you can make significant profits by keeping your trade open and allowing the trend to play in your favour.
Chart 1: GOOGL 1-hr chart with 20-period DEMA
A bearish crossover typically occurs when price crosses below the DEMA line, which could mean that a bearish trend is about to kick off. In such cases, stock traders can place short trades on a stock with a view that its price will continue falling going forward. However, this could be a false signal and the price could reverse and move against you. Always use a stop-loss order to minimise your losses in case your trade does not go as planned.
Chart 2: DEMA trade entries on the GOOGL 1-hr chart
As a trailing stop-loss order
You can also use the DEMA as a trailing stop loss order whereby your trade will close automatically once the price crosses below the DEMA line in an uptrend, or above the DEMA in a downtrend. You can do this by manually adjusting your stop loss as the price moves in your favour, or you can set an automatic trailing stop if your broker offers this option.
In all of the above scenarios, we can see that the DEMA is used in a very similar manner to the simple moving average and the standard EMA.
Using the DEMA within other indicators
You can use the DEMA in other indicators that are derived from moving averages, such as the moving average convergence divergence (MACD) indicator. This is not a common practice, and it is typically used by experienced traders who want to get faster readings from the affected indicators. Most traders find the DEMA to be a sufficient indicator on its own given the huge advantage it has over the popular SMA and EMA indicators.
Disadvantages associated with the DEMA
One of the major disadvantages that you are likely to encounter with the DEMA can also be perceived as one of its biggest strengths: it tracks prices a bit too closely. This is reflected in how the nine-period DEMA usually moves inside the price, making it hard to get any convincing signals from the indicator.
Therefore, most traders have to use DEMA values starting with the 20-period and above as it is hard to separate the DEMA from the price if it tracks a shorter number of periods, like the default nine-period DEMA.
The bottom line
The double EMA (DEMA) is a powerful indicator that eliminates the time lag associated with the simple moving average (SMA) and the exponential moving average (EMA). This makes it the perfect tool for traders who day trade stocks as well as swing traders who hold trades for up to several days.
However, the DEMA may not be the best tool for position traders who hold their stock trades for months. These traders might be better served by a slower moving MA, such as the EMA or the SMA. Traders should also avoid the nine-period DEMA, which tends to interact a lot with price, generating many false signals.