The Double Exponential Moving Average (DEMA) was originally constructed by Patrick Mulloy. DEMA was introduced as an indicator that abbreviates the amount of lag time encompassing traditional moving averages. Two exponential moving averages are incorporated in this indicator to remove the lag. The lag difference between a single-smoothed EMA and a double-smoothed EMA is used to offset the single-smoothed EMA. The result is a smooth moving average that trends closer to price movement. DEMA can be analyzed similarly to traditional moving averages.
The Formula for DEMA
Single- and Double-Smoothed EMAs:
EMA1 = EMA of price
EMA2 = EMA of EMA1
DEMA = (2 x EMA1) – EMA2
This formula takes the lag difference between the lagging, single-smoothed EMA1 and the more lagging, double-smoothed EMA2 and subtracts this from EMA1. As noted, the resulting calculation provides a smoothed line that trends closely with price movement. DEMA should be applied to confirm trends or identify a change in trend. DEMA produces signals when intersecting candlesticks, or when a relatively shorter-term DEMA intersects a longer-term DEMA. DEMA may also function as a dynamic point of support or resistance. When prices are uptrending and are positioned above DEMA it helps confirm the validity of the uptrend. When prices are downtrending and below DEMA it helps confirm the validity of the downtrend. When price intersects and crosses above DEMA it may signal the end of falling prices, along with a possible upside reversal. When price crosses below DEMA it may signal the end of ascending price movements and a possible downside reversal.
The signals that are produced from the DEMA crossover method are indistinguishable from the traditional double crossover method. When a shorter-term DEMA crosses above a longer-term DEMA, a bullish signal is produced. When a shorter-term DEMA crosses below a longer-term DEMA, a bearish signal is produced. Because DEMAs consist of less lag, crossovers usually occur before a traditional EMA crossover. DEMA moves and reorients in an expeditious manner, which means there is less capability for it to operate as a point of dynamic support or resistance. However, DEMA may allow for quicker entry and exit points and is a considerable tool when used for fast-paced trading. To appropriately determine if a DEMA will function as support or resistance, examine historical price movement, and identify if a DEMA has acted as support or resistance in the past. If the DEMA you are using has not served as a support or resistance in the past, it is unlikely to do so in the future.
Diminished lag does not constitute a more effective indicator. You will need to modify your trading strategies to allow for the successful implementation of DEMA. Indicators with reduced lag often reflect inconsequential market moves, and it may be difficult to discern between noise and meaningful price moves.
Figure 5.1 DEMA Double Crossover Method
Figure 5.2 DEMA Double Crossover Method
Figure 5.3 DEMA Double Crossover Method
Backtesting a Sample DEMA System
Entry Criteria (Long)
- Close > EMA 200
- DEMA 9 crosses over DEMA 18 (Buy)
Exit Criteria (Long)
- DEMA 9 crosses under DEMA 18
2. A 2% profit is achieved
Entry Criteria (Short)
- Close < EMA 200
- DEMA 9 crosses under DEMA 18 (Short)
Exit Criteria (Short)
- DEMA 9 crosses over DEMA 18
2. A 2% profit is achieved
Figure 1.4 All Historical Price Data – DEMA System
Figure 1.5 Out-of-Sample Data – DEMA System
Figure 1.6 In-Sample Data – DEMA System
Figure 1.7 Previous 5 Years of Price Data – DEMA System
Practical Use – Straight Talk
The DEMA double crossover method can work well, but must be backtested to ascertain efficacy. Don’t expect a high win-rate with this system. Two DEMAs are likely to cross incessantly, and most crossings result in a whipsaw/false signal. You can use other methods to filter potentially inconsequential crossings. Despite this, a DEMA double cross system is likely to incorporate a low win-rate. A position entered on a whipsaw/false signal should be closed promptly for a negligible loss. When a strong price move does occur: maximize your profits.
What are DEMAs best used for?
Profit-taking/stop-loss criteria. Assume you are long a position and prices are continuously closing above a 9 day DEMA. You might consider taking-profit/stopping-out if and when prices close below the DEMA. Inverse this strategy for a downtrend. Momentum trading won’t benefit from this too much; a retracement of the predominant trend will result in prices crossing over the DEMA. However, this method works well for swing-trading and day-trading. Good profits can be realized from a transient price swing when getting out quickly.
Figure 1.8 Using a DEMA as an Exit Strategy
Using a DEMA to distinguish quick exit-points.
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