Jim Smith, probably one of the new readers of this blog, asked me a very good question, how I decide what pair of EMAs to use in order to get buy/sell signals and why I am using different EMAs for SPX and for UUP (the dollar index)?
I touched this subject a few times in the past but I am going to give more details today. There is no other way to select a certain pair of EMAs than looking in the past and see what worked then and making the big assumption that is going to work again. Most of the time it does work, market somehow "remembers" its own behavior. EMA25 crossing EMA50 on hourly chart has worked for me for a few good years, this year the system was exceptionally good but the other years were not bad either. This pair of EMAs works for indexes, it doesn't work as well for individual stocks since they are much more volatile and a sharp move up or down it's enough to onset a false buy or sell signal. For an index ETF a move up or down above 2% it's a rare event, for an individual stock this is rather the rule than the exception.
Now let's look at UUP the dollar ETF launched only three years ago so we don't have two much data. This a perfect example for how to chose the best pair of EMAs for a certain ETF. Let's look on daily chart which give us data back to the beginning of 2009. The shorter the EMAs the sooner they are going to give you a buy signal and the sooner is going to give you a sell signal on the way down. For example a EMA10-EMA20 is going to make you more money than EMA25-EMA50 (better entry point, better exit point), but at the same time EMA10-EMA20 is going to give you more false buy/sell signals than EMA25-EMA50. What I want is the shortest pair of EMA that doesn't give a false buy or sell signal over a decent period of time, during a decent uptrend or downtrend. I know it sounds confusing so let's go back to UUP. At the beginning of March UUP reached a higher high then by the end of the month it went down no less than 7%. Was that a correction or the long term trend had changed for real? At that time I couldn't tell (well, the daily and weekly DMI turned red but let's say I couldn't have a clue). By the end of April UUP made a substantial move up but it couldn't go above the March high. In May UUP moved bellow the April's low so now we had a lower high and a fresh lower low a clear sign that UUP was in a downtrend. Looking back at the data I realized the obvious thing, that the April rally was a huge bull trap. My question now was "what was the pair of EMAs that almost gave a "buy" signal, what EMAs touched each other but without crossing because that pair of EMAs was going to give me the best entry point on the next rally? I tried different pairs and realized that EMA15-EMA30 was the one that fulfilled my conditions.
What I had to do now was to watch this pair and see if the buy and sell signals were going to be for real or not. In between "buy" and "sell" signals I was supposed to see the two EMAs touching each other but without crossing. And indeed the buy signal in December 2009 and the sell signal in July 2010 were for real. Since May 2009 when I came out with EMA15-EMA30 pair until now, the timing system was confirmed 7 times, 5 times the EMAs touched without crossing, offering and excellent support level and the buy and sell signal were also for real. So if you want to trade UUP, next time EMA15 is going to cross EMA30 on daily chart you can buy since the uptrend is most likely going to be for real. It's not 100% guaranteed but the chance to be on the right side of the market it's huge.
Different ETFs have slightly different pair of EMAs that works for them. Also you need to decide what time frame are you interested in, long term, short term, intermediate term (my favorite) or are you interested only when market switches from bear market to bull market or the other way around (for this I am using EMA100 crossing EMA200 on daily chart).
This is how I came up with EMA25 crossing EMA50 on 60 minutes chart for SPX, this is how I came up with 19 days SMA as a confirmation of the EMAs crossing, by testing and testing and testing different indicators. You are not going to find this timing system in any book, you will hardly see DMI mentioned in any book, this is my baby, I came up with this system so you should take the trading advices on this page with a grain of salt. I don't have a background in economics, but at least one person, my kid, thinks that I am the smartest person in the World :) Of course when I am giving him as much candies as he wants. Otherwise...
