Technical Analysis Challenge Day 3 - EMA

Hello everyone, in this post, I am going to share about EMA, or exponential moving average.

The key difference between EMA and simple moving average (SMA), is their way of computation. SMA simply calculates an average of price data, EMA applies more weight to data that is more current.

As a long term investor myself, SMA is my preference. However, EMA is normally preferred by shorter term trader or investor. There is not right or wrong, it totally depends on the stock characteristic and individual preference. Some stocks tend to rebound on EMA, some on SMA.

However, EMA is still a lagging indicator. Even it weights more on the recent price movement, it is still suffered from the limitation of all the lagging indicators- it could not anticipate an upcoming trend forming. Moreover, by weighing more on the recent price, it has a new weakness that is normally found from the leading indicator: Prone to giving out false signals.

In this post, I will be sharing how I combine EMA with other indicators to warn me “NOT TO” buy or sell. While it is important for us to know when to buy or sell, to me, knowing when NOT TO buy or sell, is equally important.

Last year, I have prepared a video on the warning signal, if you are interested, you may watch the full version here:

In this post, I will be focusing more on th EMA, the key challenge of the event.

Warning signals are set of signals that tell me the probability of market correction is high.

In total, there are 4 + 1 indicators that I use as my warning signals. I will first use Nasdaq daily chart as an example to show how to apply these indicators. The first one is exponential moving average, EMA20. For the detail of moving average, you may refer to my previous video here. In short, EMA20 is measuring exponential move of the stock for 20 days, which is considered as a short term movement.

1st indicator: EMA

The pink line is EMA20. What do you observe in this chart?

1st: EMA serves as as weak support for Nasdaq.

2nd: The more important point: When it moves further from EMA20, it tends to pull back to EMA20. Either bound on it or plunge through it.

Thus, when the stock is moving far away from EMA20, it signifies the stock could be pulled back anytime.

Now, let us imagine EMA20 is a rubber band. When we stretch the rubber band, the more we stretch (EMA moving further), the resistance is higher, and at one point, if we release the strength, it will be pulled back (stock pull back to support). Sometime, the rubber band may be broken off (stock plunges below the support level).

Summary: The 1stindicator used in my warning signal is EMA20. The further it moves away from the EMA20, the higher probability the stock will be pulling back.

Well, we know that stock tends to pull back to its support, such as EMA20. However, we do not know how far it can stretch until it pulls back. Thus, here we can introduce second indicator: Bollinger band

Take note that I removed the MA9 from the default Bollinger band, as I will be using EMA20 instead.

Bollinger band consists of a central moving average. In this case, I will be using EMA20. There are two lines, one above and one below the central EMA20 respectively. The distance of the bands is based on standard deviation, which also indicates volatility. I am not going into details of the Bollinger band as I am not using this as a trading signal. I will just share on how to apply this indicator as a warning signal.

It is very straight forward, when the price hits the upper band, the price is relative high. If it hits the lower band, the price is relative low. You may also notice that the prices have a tendency to bounce within the bands' envelope, touching one band then moving to the other band.

Imagine you are in a tunnel with a lot of trampolines on the top and the bottom of the tunnel. You will find that you are bouncing in between! Thus, when the price moves far from EMA20 and touch the upper band, it signifies the price could bounce back to the support or to the lower band anytime.

The stochastic oscillator is my 3rdindicator for my warning signal. The stochastic oscillator is a leading indicator, which is measuring the recent closing prices to the previous trading range. You may wonder since stochastic oscillator is still using recent closing price to compute its value, why is it considered as a leading indicator?
Let’s use this analogy. You are a marathon runner. Before the race starts, your energy is at the max level. When the race starts, you run very fast. The momentum is strong! You are running faster and faster. This is where the stochastic oscillator moving up. At one point, you will start to be feeling tired. This is where the stochastic oscillator at the top, or overbought region. At this level, your energy is exhausted. You need a break. Thus, your start to run slower. Now, your running pace is relatively slower than your previous speed. Your momentum decreases. This is where the stochastic oscillator is going down, or, the price is pulling back.

When you are starting to feel tired in marathon (which is at market high), I will anticipate you will be running slower later (price pull back). When you are running slower and recharging to gain back your energy (market low), I anticipate you will be running faster later (price going up).

Thus, the stochastic oscillator is based on the idea that market momentum changes direction much faster than price movement, which taking into account the highs and low in a recent range, so it can be used to predict the direction of price movement.

Let us look into the stochastic oscillator. We have a red color K line, and purple color D line. We also have a reading of 80 and above as overbought region, and a reading of 20 and below marks the oversold region. In general, when K line crosses above D line and move upward, it signifies the upward momentum is increasing. Conversely, when the D line crosses K line and move downwards, it signifies the downward momentum is increasing. But for warning signal, I will only focus on one region: Overbought region at the reading 80 and above for NOT TO BUY, and below 20 as NOT TO SELL. This is where the market is starting to feel tired, and the price could retrace back anytime. This is where we can use the stochastic oscillator in conjunction with EMA 20 and the Bollinger band, to double check if the market is prone for a correction soon.

My last indicator used in my warning signal is a well-known indicator, RSI, or relative strength index. RSI is also a leading indicator. RSI is also measuring the momentum of a price movement. It is very straight forward to read RSI: When it reaches 65 and above, the stock is considered overbought. When RSI is at 30 or below, it is considered oversold.

Then, why do I need both the stochastic indicator and RSI in my warning signal? This is because they are computed in a different way. A stochastic oscillator is based on the assumption that an assets current price will be closer to the highest price of its recent price range. In other words, stochastic oscillators use closing prices but also include the highs and low in a recent range. Whereas, an RSI would include just the closing prices of a recent trading period. As a general rule, the RSI indicator can prove more useful when markets are trending, while the stochastic indicator can be more insightful compared to the RSI in flat or choppy markets, where there is no clear trend.

Thus, by including both RSI and the stochastic indicator in my warning signal, I manage to monitor the market to provide me more insight on the potential pull back at various market conditions.

This is the summary table for the warning signals used.

Overall, these four indicators are computed in different ways and thus, if they are pointing towards a potential correction, the likelihood for the market correction is high. When 3 out of 4 of these indicators converge to overbought region, I will not buy. If 3 out of 4 of these indicators converge to oversold region, I will not sell!

The orange boxes are the period where both 4/4 signals converge into overbought region. After both 4 signals converge, it told me NOT to BUY! Then we shall see the stock price retraced.

i) I do not recommend in timing the market. In short, market timing is the strategy of making buying or selling decisions by attempting to predict future market price movements. In a bull market, the warning signals should not be used an indicator to predict the downward movement of the stock as a decision to sell stocks or short sell the market. Opposite is true during a bear market, where we should not time the market to predict the bottom with the warning signal.

ii) Warning signals only tell me the probability of the market correction is high. It is not a buying or selling signal. Buying or selling signal should be based on your trading strategy.

i) Buy more/ sell more

ii) Sell or buy to profit take or cut loss

iii) Do nothing

These are the information that warning signal tells me about:

- Do not buy or Do not sell, wait patiently for the dip or the rally

- Do nothing. Just wait. Sometimes, do nothing could be one of the best actions.

Important: The warning signals are not intended to be used for these purposes:

In a bull market: Sell all stocks and wait for the dip. This is timing the market. The stock may just go higher and you miss all the profits. Opposite is true for a bear market.

Short sell the market. Warning signals are not selling signal nor short sell sign

That is all I would like to share for EMA challenge. Thank you and see you in the next video.