Trading the 5 EMA and 8 EMA crossover strategy
Moving averages are one of the most simplest of all technical indicators. This is a fact because moving averages are mathematical in nature. They can represent when price of a security is rising or falling. The simplistic nature of the moving averages makes it one of the most popular technical indicators to use in technical analysis.
There are many strategies when one talks about the moving averages.
Crossovers of two moving averages is one of the most basic strategies that one could use.
This happens when traders apply a moving average from a longer period and add another moving average from a shorter period.
When the short period moving average crosses over the long term moving average from below, it is known as the golden cross. This is essentially a buy signal with the moving averages telling you that prices are in an uptrend.
Likewise, when the short term moving average crosses over the long term moving average from above, it is known as the death cross. This signals to the trader to sell and it happens when prices are in a downtrend.
One of the key things for a moving average strategy to work is the lookback period. There is basically no limitation on the lookback period. Still, many traders observe a general guideline.
On the daily time frame for example, the 200-day, 80-day and 100-day moving averages are commonly used. You can see the financial news networks making a lot of hype when one of these combinations of moving averages tend to make a golden or a death cross. It is an important milestone and is therefore closely watched.
What makes the moving averages so popular is that a lot of trading strategies can be built around these indicators. You can use a combination of various trading oscillators and other custom indicators alongside the moving average to build a trading system.
Still, the crossover based moving average system is one of the most popular largely because of its simplicity. Automating such trading strategies is also very simple to implement.
When one talks about two moving average crossovers, the first thing that comes to mind is the lookback period. In this article, we look at how to trade in the short term using two moving averages.
As the title suggests, we will use the 5-day EMA and the 8-day EMA. EMA stands for exponential moving average. It is one of the many types of moving averages that you can use. There are some distinctive advantages of using the EMA.
The next section talks about what an exponential moving average is all about and how it is different to its close cousin, the simple moving average. It is important that the trader has this basic knowledge before diving into how to trade with two period moving averages.
This will not only make the 5EMA and 8EMA moving average crossover strategy more easy to trade, but you will also be able to fully understand and trade with confidence using this very simple trading strategy.
How is EMA calculated?
EMA or exponential moving average is one of the most popular moving average types that is used. This is due to the fact that the exponential moving average gives more weight to the recent price action. This keeps the EMA more relevant to the recent volatility rather than smoothing the average price for the lookback period.
Due to this feature, the calculation for the exponential moving average can be a bit complex compared to other. Still, we first start by understanding how the simple average is calculated.
As the name suggests, a simple moving average is basically the average price over the number of periods. For example, a three period moving average would calculate the average of the precious three closing prices.
The simple average (and also the exponential moving average) plots continuously as and when new sessions are closed. So, for example if the price over the past five periods was 10, 11, 12, 13 and 14, then the simple moving average would be (10+11+12+13+14)/5 = 12.
When it comes to the exponential moving average, the calculation is not that simple. The mathematical formula for calculating the exponential moving average is as follows:
EMA (current period) = [Current Close x K] + [EMA (-1 period) x [1 - K]]
K = 2 / [N+1]
N is the lookback period of the EMA
You can use a combination of various prices such as open or high or low or close. Many traders prefer to use the closing price as this is the most important of the four price levels.
Most of today’s charting platforms automatically plots the EMA for you. Therefore, there is no need to manually do the calculations. Still, it is important that traders have and understanding of how the exponential moving average is plotted on the chart.
The better your understanding of how the EMA is plotted, the higher the chances for you to build better trading strategies around it and it will also help you to avoid using indicators that are redundant.
To better understand how the EMA is slightly different from the SMA, let’s look at the chart below. Here, you can see that the black line is the exponential moving average, while the blue line is the simple moving average.
The look back period is a 20-day period and applied to the daily closing prices on the daily chart time frame.
Difference between EMA and SMA
In the above chart, you can see that the EMA or the exponential moving average is actually more leading and responsive to the price action comparing to the simple moving average. Thus, traders use the EMA due to the more responsive nature of the exponential moving averages.
How to trade with the 5 and 8 exponential moving average?
To begin with, we should first set up the chart. We use the daily chart time frame. This chart time frame is selected because it is a lot easier to trade on the daily charts. You also do not have to be stuck to your trading terminals all the time.
This makes it a lot easier to manage your trades. Although we use the daily chart time frame, the trades we take are short term in nature. In other words, the trades are kept open for a few days only. This ensures that although you are trading the higher chart time frame, the trading lifespan for the trades is relatively short in nature.
The chart below shows the three period and five period exponential moving average applied to the daily chart of gold. The blue line is the 5 EMA and the black line is the 8 EMA.
5 and 8 EMA trading strategy – Chart set up
In this strategy, we do not wait for the moving averages to tell us when to buy or when to sell. On the contrary, we will look at price when it is at an extreme from the two moving averages. Following this, we then look for a reversal (bullish or bearish) candlesticks and then enter the trade.
By doing so, we are essentially entering the trade a bit early. This gives us the advantage of being able to capture more profits compared to waiting for the two moving averages to signal the buy and sell conditions for us.
Let’s look at an example of a sell set up in the next chart below.
5 and 8 EMA crossover – Sell set up
In the above chart, we have the area marked by the down arrow after we see a strong bearish candlestick being formed. Prior to this, we have the inverted hammer or a near hanging man looking candlestick pattern.
When the bearish candlestick closes below the open of the previous two session’s we place a pending order at the open of the candlestick (-2 bars, or 2 bars ago) and place our stops near the high.
The targets are set to 1:1 and 1:2 respectively followed by the last position being kept open to take as much profits as the markets give.
You can see that in the above example, we went short right when the 5 and 8 EMA gave a bearish sell signal. Price eventually moves to our take profit 1 and take profit 2 levels. The last position is trailed until we get stopped out for a profit, no matter how small it may be.
The next chart shows an example of a buy set up.
5 and 8 EMA crossover – Buy set up
In the above chart, we have an example of a buy set up using the same methods outlined in the previous sell example. Here, we see a doji pattern emerging. After this, we place a long position at the open of the previous bearish candlestick with stops at its low.
The targets are set to 1:1 and 1:2 levels. You can see that price instantly breaks past the entry level and hits the first take profit level. A little while later, price then touches the 1:2 take profit level.
From both the examples, you can see that the duration of the trades being kept open spans across a few days only. This makes it easier for you to manage the trades.
One of the important things to understand when trading with the three and five period moving average is that you need to have a good trend in the markets. This can be a bit difficult to gauge initially. Therefore, traders need to have enough practice to know when the markets are trending and when they are not.
This is one of the reasons why we choose the daily chart time frame. Trends on this level are established strongly. You avoid the day to day market noise as well which makes it easier for you to adjust your stops accordingly.
In the above examples, we combined price action with the moving averages. You can of course use oscillators such as the RSI or the Stochastics oscillator to validate the buy or sell signals further.
But remember that the more indicators you use, the more lagging the signals tend to be. Thus, there is a great chance that you could actually miss a good part of the price action if you only rely on the buy and sell signals given by the indicators.
Due to the fact that we maintain a 1:2 risk/reward set up with the option to trail the stops on the last position, this approach can help you to build your equity on a steady level.
The 5EMA and 8EMA crossover strategy – Conclusion
In conclusion, the 5 and 8 exponential moving average strategy is a very basic but short term trading strategy. In our examples, we choose the daily time frame as it is easier to also make use of candlestick patterns.
While the strategy looks simple you can further enhance it using various other technical indicators. However, traders should ensure that they do not end up adding too many technical indicators besides the two EMA’s that already exist.
Keeping a trading strategy simple will ensure that you are better able to understand price and manage your trades accordingly.
Therefore, traders are free to simply implement this trading strategy or build upon it.
There is a bit of subjectivity involved with the above presented trading ideas. But traders could also look at other options such as automating the technical trading ideas presented here.
Back testing these trading strategies will make it easy for you to see whether this can be a valuable trading strategy that you can implement. The 5 EMA and 8 EMA trading strategy can be applied to any market of your choice.
If need be, you could also make use of this trading strategy on intraday chart time frame as well. The main thing is that you have a good understanding of how this short term trading strategy using two moving averages work.