Introduction
Within the massive world of stock trading you can encounter every type of challenge imaginable and this will include lag and understading the many intricacies of how markets have been performing thus far. Intricacies like uptrends, downtrends or whether it’s a reversal the market is due for.
Its stuff like this that can make the role that indicators like moving averages play all the more evident if you ask me.
Now that we’re on the topic of moving averages you’ll find many of them littered throughout the landscape and each of them is calculated differently and has various unique uses.
The EMA, WMA, SMA and whatnot are just some of the many indicators out there. But here we wont be looking at either of those. We will direct our attention straight towards the DEMA or Double Exponential Moving Average.
What is DEMA (Double Exponential Moving Average)?
So what is the DEMA then? You can get a hint by just paying more attention to its very name, i.e., the “Double Exponential Moving Average,” which just means that you have two exponential moving averages being used here. Now what are those you might be wondering?
EMAs are a type of moving average that places more emphasis on recent data points rather than weighting everything equally like those SMAs do. But who created it you might be wondering?
Well it’s inception may be found during the 1990s with Patrick Mulloy being the founder. He first introduced it within the article named “Smoothing Data With Faster Moving Averages“. Now this was first published in the Technical Analysis of Stocks & Commodities magazine if you were wondering,
The Purpose of DEMA
But what is the DEMA’s point anyway? Why was it made? Well the point is to lower all that noise or lag that you get from traditional moving averages.
But where it’s not all that different from its traditional brethren is how it can indicate the trend that the stock’s price is going through.
By keeping track of that enough, eventually you’ll be able to spot uptrend, which just means the price is over its average, and downtrends, which mean that its below that average. If you know what you’re doing, you can play those trends in your favor.
How is DEMA Calculated?
While you wont have to caclulate those DEMA values on your own since the vast majority of trading platforms that provide it will do it for you. However if you’re curious about the matter then read on.
DEMA Formula
So here’s the formula you’re curious about:
DEMA = 2 X EMA(n) – EMA of EMA(n)
Key Characteristics of DEMA
But knowing your formulas is one and actually calculating them is another. There’ll be four steps you have to undertake if you’re calculating it yourself. The first is to choose a lookback period which may be five, 15 or even 100, whatever it is that suits your needs.
Following that you will have to find out the EMA for your period and this is essentially the EMA(n).
The third step has to do with applying the EMA that comprises the exact same lookbakc period to the EMA(n) thereby smoothing the EMA. Just multiply the EMA(n) twice and then substract it from that Smoothed EMA.
So the key characteristics based on what we’ve so far discussed would have to be the EMA and the lookback period as both of them are important in calculating that DEMA.
How to Use DEMA in Trading
You must know a bit about what the DEMA is by now which makes it the right time to see how you can apply all that knowledge in doing some actual trading.
Trend Following with DEMA
One of the more obvious use cases of the DEMA is that you can use it to follow trends. Knowing the performance of the market goes a long way in generating successful trades.
If you have an uptrend and you’ve been hodling all this while then this could imply that you might want to start to begin sellng soon.
However if you see some downward pressure on the price and when you may have to start purchasing for an uptrend later or even selling to stop your losses if you have been holding on.
But again these are just some ways of going about it when analyzing trends. There’s more you can obviously do.
DEMA Crossovers
Sometimes people like to use two DEMA lines as a part of their trading strategies. Here you have one long period line and one short period. Both these lines represent the short and long term trends respectively.
So when that short DEMA line crosses over the long one, it could be a bullish signal meaning that the short term trend is slowly becoming stronger than the longer one, so you may want to start buying then.
But if you see the short term DEMA line moving below the longer line then you might have a bearish signal on your hands, and if that does happen, you may want to start selling then.
DEMA and Price Action
Another interesting approach that traders often employ in their DEMA strategies, is looking at the relationship the price has with the line, and what it means when you have crossovers.
So if you see the DEMA going over the price that could be your bullish trend. But if you experience the exact opposite, where the crossover takes place with the line going below the price then you have a bearish trend.
You can use charts to make it easier or yourself if you want a more visual indication of these instances. You could use other indicators to confirm those trends if you aren’t sure too.
DEMA Strategies for Different Trading Styles
Now let’s see how the DEMA relates to some of the popular trading styles like day, swing and long-term trading.
Day Trading with DEMA
Since day traders priorities lie mainly on short-term gains, they could just adjust the time frames to suit their needs. They could therefore employ shorter lookback periods and may adopt a scalping strategy to really make use of those periods.
Swing Trading with DEMA
For the swing traders, whose focus pertains to medium to long term profitability, their lookback periods can be reflective of that naturally. Since they’re giving themselves more time they could benefit more from crossovers between price or two DEMA lines.
Long-Term Investing with DEMA
Since DEMAs react more quickly than conventional moving averages swing and day traders are the ones who’re more likely to use them.
So for long-term traders who may not place that much weight to recent data, they may opt for a more conventional moving average instead, like an SMA or something.
Advantages and Limitations of DEMA
Any trading indicator is likely to be accompanied by its own set of limitations and knowing those is just as important as knowing the benefits. That way you’re more prepared for the risks.
Benefits of Using DEMA
Starting with the benefits you have how it reduces the lag and noise by being more reactive to recent price changes. Because of that day and swing traders may find this indicator more to their liking as it can give them the signals that they’ve been looking for.
Limitations of DEMA
Now with the drawbacks, you obviously won’t find it much useful in times when prices are choppy as no worthwhile trend may be identified during that. Additionally the fact that it reduces lag can be to its detriment too.
How? Well the trader may be prompted to sell sooner than is necessary, thereby missing out on better opportunities.
Conclusion
The DEMA is a sophisticated trading tool that you could use to be a more competitive trader within the stock markt.
After all its unique features like reduced lag, accurate signal identification with customizable parameters has made it quite a popular choice with traders who like technical analyses.
But that just doesn’t mean you can gloss over those drawbacks it has as the false signal possibilities are by no means completely donw with.
It is a bit sensitive toward price fluctuation and you don’t want to over optimize too. So just keep that in mind whenever you plan on using this indicator.
What is the difference between DEMA and EMA?
The only major difference is that the DEMA incorporates two EMAs in its calculations and that’s it. The reason behind that is to quickly react to price changes
What is the best period setting for DEMA?
Like we said earlier the DEMA is more suited to day and swing traders so the best period settings would likely be reflective of that
Can DEMA be used for all asset classes?
Not really, as it may not perform as well with assets that rarely fluctuate in their prices, i.e., assets with flat prices
How can I avoid false signals with DEMA?
The best way to avoid false signals with DEMA or any other indicator for that matter is to use other indicators for additional confirmation. So, you may want to include the RSI for example if you’re not sure of the DEMA’s findings
Is DEMA better than EMA or SMA?
It’s better for certain types of people but not for everyone out there obviously. Long term traders may find the SMA more to their liking because it places equal weights to every data point and that could make gauging longer trends more effective