- February 22, 2022
- Posted by: CoachShane
- Categories: Trading Article, Trading Indicators
The double exponential moving average (DEMA) uses two EMA’s in the formula to help eliminate the lag time involved with all price based technical indicators. The DEMA is considered an improvement over the standard moving average by using a smoothing feature of the exponential moving averages (EMA) and the standard EMA.
Patrick Mulloy invented the DEMA in the 1990’s and wanted an indicator that could take out some of the lag associated with moving averages. While 100% removal of lag is not possible with indicators derived from price, this reduction in lag produces an indicator that is more responsive to price changes.
This daily stock chart of Apple has the DEMA, the EMA, and a simple moving average overlayed. All periods are set to 20. It is clear that the DEMA stays extremely close to price which will have the indicator reacting quicker to changes in price than the other two.
The quicker reactions may suit the needs of short-term traders and swing traders as they look to be responsive to changes in the volatility and trend reversals in price. Longer term investors may not be as concerned with getting shorter term changes in the market unless the longer term trend is affected.
How to Calculate the Double Exponential Moving Average (DEMA)
Mulloy explained in Technical Analysis of Stocks & Commodities magazine that he used the following for the formula: DEMA = ( 2 * EMA(n)) – (EMA(n) of EMA(n) ).
N is the lookback period which can be any number you choose.
While it may look confusing, we simply:
+ Multiply a standard EMA by 2
+ Use another EMA with the same look back which acts as a smoothing EMA
+ Then multiply the EMA by 2 and subtract the smoothed EMA
Essentially, we are using the EMA of an EMA for the indicator plot that appears on your price chart. While knowing what is behind the indicator is useful, your trading software will do the heavy lifting for you.
Trading With The DEMA
At it’s core, this is just another moving average and traders will use it much in the same way as any other one.
From trend direction and support and resistance to using moving average crossovers, there are a variety of ways to use them in your trading strategy.
One thing that is important is the lookback period.
Because of the lagging feature and how you plan on using the DEMA, some periods mingle with price making them not too helpful.
One feature of a moving average that is helpful is when the average “snakes” through the candlesticks. This is often a sign of a choppy market and the formation of trading range.
If using the 9 period black line, the indicator stays inside of price for a majority of the time even when price is trending. That takes away the choppy market indication and a trader would need to read price action for that market condition. The 20 period green line and the red 50-day DEMA don’t engage with price as much.
The lower the lookback period, the more volatile the indicator will be. A higher setting has less whipsaw and may be more useful.
Support and Resistance
This is where price will seemingly be bouncing off the moving averages. I personally don’t follow that line of education and discard the notion that moving averages act as support and resistance. There are many types of moving averages, from the Hull to the a simple average and it is naïve to think “institutions watch them” which is why they work.
When you find price reacting to an area around any moving average, look left and you will no doubt find some price structure that is holding price.
With the less lag feature, using the double exponential moving average as a trend filter as you do other moving averages is viable. In this case, you would be alerted to a change in direction earlier than a standard moving average.
The key is what you determine to be a trend change:
+ Is it the slope of the moving average?
+ If price crosses the average, did the trend change direction?
+ Do you need price holding above or below the DEMA for a change in trend?
On this daily chart of Bitcoin using a 20 period DEMA, we have multiple trend changes using price trading above or below the average.
For this example, we look for price to break the average and then have some trading activity after the break. We would ignore weak breaks and look for those that are done with some momentum. We can also look for lows above or highs below the average to signal a change as shown in the next example.
In the chart below, we have price breaking the DEMA and plotting two higher lows completely above the average or two lower highs below.
We would consider a break of the highest high or lowest low as confirmation of the trend change.
Traders would then use whatever trading strategy they use to find an entry point into the market for a trade.
Using Two DEMA Indicators
A very popular approach to trading is the crossover of two or more moving averages as part of a trading strategy. While trading the actual cross is not a suggested approach, we can use the indicators for a trend determination and an area of value for a pullback.
For a trend change, we would use the trend direction method we’ve already discussed. We are able to add another layer of confirmation by requiring the 15 DEMA have crossed over or below the 50 DEMA.
Traders would look for a pullback into an area of value between the 15 and the 50. Bear flags and bull flags, along with triangles, are my favorite patterns to look for on the charts. Using the area of value ensures that price is showing a reaction against the main direction of price. This avoids trading in a slow grinding market as we can see on the left of this chart.
Using the most recent price data can go a long way in your ability to read the current state of the market. The double exponential moving average, because of the calculation, will react faster to market changes which may benefit a certain style of trader.
The lookback period you are going to use, matters. A 9 period lookback will be wrapped up in price for a lot of the time, making it rather useless. The upside to the faster DEMA, is if price pulls far away, we can determine there is strong momentum in the market and look to play consolidation breakouts in the direction of the trend.
There is always the question: does a trading indicator work? The problem with that question is defining what “works” means. All a technical indicator does is present information in a certain way. What you do with that information is what determines if it works or not.
I hope you enjoyed reading about the DEMA.
For further trading information to help you build a trading strategy, I think you will find the resources below, useful.
Charts courtesy of Tradingview