EMA 12 And EMA 26 trading strategy explained
The EMA 12 and EMA 26 trading strategy combines two different exponential moving averages. This trading strategy is simple as using regular moving averages. However, there are some subtle differences with this type of a trading strategy. It is mostly used by day traders.
A moving average as the name indicates, is the average price of the security that is being analyzed.
Moving averages have been long used in technical analysis trading. The moving average indicators are widely used both by retail traders as well as professional traders.
If you look to any financial TV channels, you can often find professional traders discussing price and its relation to the moving average indicator.
It is also one of the most commonly found indicators in just about any trading platform or charting interface. This goes to show the importance of the moving average indicator.
On the MT4 trading platform, the moving averages can be found under the “trend” indicators. This is because the moving average indicator is used to determine the trend in the price.
In this article, we take a look at the EMA 12, 26 trading strategy and how you can use this strategy to trade the markets.
But before we get into more details, we need to cover the basics. In the next sections, we start with the definitions of what EMA means and also cover the difference between the SMA and the EMA. Finally, we will go into the details of an exponential moving average trading strategy.
What EMA means?
EMA is the short abbreviation for exponential moving average. This is a type of moving average that is widely used in technical analysis of the financial markets.
A moving average is merely the average price plotted on a price chart. Because the average price is plotted continuously it is called a moving average. There are many different types of moving averages.
These moving averages are basically the same, the exception being that the method of calculating the average price varies. For example, at its most simplest form, the average of two numbers is derived by summing the two numbers and dividing it by two. This is nothing but a simple average price.
To add the moving average indicator to you charts and to select the exponential moving average, you can double click on the moving average indicator which opens the indicator’s configuration window.
From here, you can select Exponential moving average from the dropdown followed by the time period.
Exponential moving average indicator configuration
The shift functionality can be ignored. Basically, the shift allows you to shift the calculation to a few bars before the current price or a few bars after the current price. As far as the EMA 26 and 12 strategy is concerned, you do not need to bother with the settings for shift.
What is EMA trading?
EMA trading or exponential moving average based trading is a strategy that involves using the exponential moving average indicator. There are many ways to trade with the EMA. For example, you can simple combine two periods of exponential moving averages on the charts.
Usually, these two indicators of different periods are of different time periods. One is a short period and the other EMA is of a longer period. When these exponential moving averages cross each other, bullish and bearish signals are generated.
When the short period EMA cuts above the longer period EMA, it is a bullish signal. This is because by logic, when the average price of the short period EMA is higher than the average price of the long period EMA, it tells you that prices are bullish.
Similarly, when the short period EMA cuts below the longer period EMA, it is a bearish signal. This is because when the short period average price is lower than the longer period average price, it indicates that the markets are bearish.
The chart below illustrates the EMA trading with the short period and the long period EMA’s on the chart.
Besides the above, EMA trading is also referred to any trading strategy where the exponential moving averages are used.
Traders tend to generally add another indicator such as an oscillator which helps to determine the overbought and oversold levels in the markets. Thus, a trading strategy can be derived simply based off two EMA’s of different periods and an oscillator to pick the turning points in price.
Exponential moving average formula - How is EMA calculated?
The exponential moving average follows the same concept of calculating the average price with the exception that there are a number of different variables involved.
To calculate the exponential moving average, we first need to get the simple moving average for a particular period of time. We already covered how the simple average is calculated.
After the simple moving average value is calculated the next step is to use a multiplier. This multiplier is used to smooth the curve of the moving average indicator. The multiplier is based on the following formula:
[2/(time period +1)]. For example, if you were to calculate the multiplier for a 50-period exponential moving average, the time period is replaced by the number 50.
This gives a value of 0.0392.
Now that we have the simple moving average price and the multiplier, the final step is to calculate the current period's exponential moving average. For this, we use the formula of [Closing price - EMA of previous period] x multiplier + EMA of previous day.
The calculation for the EMA might look a bit complicated when compared to the simple moving average. However, the main aspect of using the exponential moving average is that it gives more relevance to the recent price action. This is done because in the financial markets, the current price is more relevant compared to past price.
Also, volatility can rise and fall at regular intervals. Therefore, the EMA is seen to be more applicable to real time trading. You might be wondering now how the exponential moving average differs.
We will cover this in the next section.
What is the difference between EMA and SMA?
As mentioned earlier, both the exponential moving average (EMA) and the simple moving average (SMA) belong to the same category of moving average indicators. These indicators are plotted on the chart and show the average price as a continuous line.
The basic premise of using the moving averages it to see whether the current price is above or below the average price. Depending on where prices are traders can ascertain how the trend is. In a downtrend, you can usually expect price to move below the moving average line.
Conversely, in an uptrend, you can expect price to move above the moving average line.
While both the EMA and the SMA are similar, the main difference is the way the average price is calculated. While a simple moving average takes the general average of prices, with the exponential moving average, more weightage is given to the recent price.
In the above chart, you can see that the blue line is a 50-period exponential moving average while the black line is the 50-period simple moving average. The difference in the calculation is aptly reflected by the way the SMA and the EMA are reacting to the prices.
You can see the visible difference of how the exponential moving average is more reactive to prices compared to the simple moving average price indicator.
The exponential moving average was derived to also account for the current market’s volatility. With a simple moving average, you basically get the general average price. Any volatility that you see is generally smoother especially if it comes after prolonged periods of sideways price action.
As a result, some traders prefer to use the exponential moving average. The reasoning behind this is that because prices are volatile, the exponential moving average is more reactive to the current developing price action.
Therefore, any volatility that you see in the markets is already reflected in the exponential moving average. If you were to use a simple moving average on the other hand, you will expect to see a very smooth moving average line.
Any reaction to the recent volatility in price will only be reflected by the SMA at a later stage in time. Because volatile markets can briefly send prices above or below the moving average line, traders prefer the EMA which shows the average price which is more up to date.
EMA 12, 26 strategy – How it works?
The EMA 12, 26 trading strategy is basically simple. It works on the same concept of the 12 period EMA crossing over the 26 period EMA. The 12, 26 period is selected because this is the most popular setting for the EMA when it comes to short term trading.
In fact, another popular indicator, known as the Moving average convergence and divergence (MACD) derives its values from the EMA 12, 26 strategy set up.
Other settings for the EMA include the 50 and 200 day moving average but this is mostly used for long term swing trading.
The chart below shows the 12 and 26 period EMA applied to a one-hour chart. The blue line represents the 12 period EMA while the black line represents the 26 period exponential moving average.
The trading signals are taken based off the bullish and bearish crossover. An important point to note is that the 12 and 26 period EMA can be a bit volatile as the indicator reacts to the volatility in prices. Therefore, traders need to be aware of this risk when trading with the 12 and 26 period exponential moving average indicators.
The trading rules are simple with this method. You take a long position when the 12 period EMA is above the 26 period EMA and both the EMA’s are sloping upward. You can trade on an intraday basis and set your stops to the nearest swing point level.
Profits can be based on a 1:2 set up or you can trail the stops to lock in some profits.
Short positions can be taken when the 12 period EMA is below the 26 period EMA. In this scenario, pay attention to the slope of the EMA’s. When the EMA’s are sloping they indicate that the trend is strong. It is also best to always buy or sell when price is near the two EMA’s.
This is because when price moves away from the EMA’s there is a tendency for price action to revert to the mean. The mean here is nothing but the average price depicted by the moving average.
The above mentioned 12 and 26 period EMA trading strategy is a very simple strategy. Traders can build upon this basic concept by adding indicators or other technical analysis such as support and resistance levels and chart patterns.
the 12 and 26 period EMA trading is one of the most simplest and easiest of trading strategies. It follows the sample principles of long term moving average crossover based trading strategy.
As mentioned, the values of 12 and 26 are the most popular for intraday traders. This is similar to the long term swing trading strategies, which use the 50 and 200 period EMA’s.
In conclusion, the exponential moving average is one of the many types of moving average indicators that are available. The moving average is nothing but the average price over a period of time. It is plotted as a continuous line and traders use the moving average to determine the trends in the price.
When prices are above the moving average, it is called an uptrend and when prices are below the average price it is called a downtrend. Because the moving average represents the average price, you can expect price to quite often retrace to the moving averages.
Using the above information, traders can now build or develop upon the concepts outlined here to design new trading strategies or develop automated trading solutions with the exponential moving average being at the heart of the trading system.