A Simple But Effective EMA Trading Strategy to Trade Pullbacks

There are many ways to trade the market using the Exponential Moving Average (EMA).

But the most common way traders use these EMAs to trade is with the trend.

The concept is simple…

Let’s use two EMAs with different periods as an example.

If the lower period EMA crosses above the higher period EMA, then the market is deemed to be in an uptrend.

And if the lower period EMA crosses below the higher period EMA, then the market is deemed to be in a downtrend.

But here’s where many traders go wrong…

Many beginner traders see the crossover as a signal to go either Long or Short.

If the lower period EMA crosses above the higher period EMA, they go Long.

And if the lower period EMA crosses below the higher period EMA, they go Short.

That’s a surefire way to go broke.

You can see in the chart above that if you had gone Long or Short each time the EMAs crossed over, you would constantly be stopped out of your trades.

You see, this method of trading the EMA crossovers did work decades ago when computerized charts weren’t invented yet and traders had to hand-draw their charts.

But ever since the digital age came along where any trader can have access to charts and dozens of indicators, that EMA crossover trading strategy no longer worked.

So instead of entering into a trade when the EMAs crossover, use it as an indication that an uptrend or downtrend might be forming.

Now, you might be wondering…

“How then can I use EMAs to get into a trade?”

The answer…

Trading pullbacks.

Using EMAs to Trade Pullbacks

So what are pullbacks and why trade them?

One of the most popular trading strategies when trading any market is to trade pullbacks.

Pullbacks are also commonly known as retracements.

And the reason they are very popular is that when markets trend, they do not just go up in a straight line.

There’s always a period of “rest” before continuing the trend.

It’s like going on a long road trip and taking toilet breaks every once in a while before continuing on the trip.

When markets are in an uptrend, they form higher highs and higher lows.

These higher lows are the “pullbacks”.

Conversely, when markets are in a downtrend, they form lower lows and lower highs.

In a downtrend, these lower highs are the pullbacks.

Markets ALWAYS have these pullbacks when trending and these are great opportunities for traders to get into a trade before the market resumes its trend.

So how do you trade pullbacks?

While there are many ways to trade pullbacks, by far my favorite way to do so is using an EMA trading strategy.

Why Use EMA and Not SMA?

First of all, I want to address why we are using EMAs for our pullback trading strategy.

While there are many different types of moving averages, the two commonly used ones are the EMA and Simple Moving Average (SMA).

So for trading pullbacks, why do we want to use the EMA and not the SMA?

Well, first of all, I want to state that both moving averages are viable to trade pullbacks.

But here’s why I prefer using the EMA:

If you were to plot the EMA and SMA on the chart, you will notice that the EMA tends to stick closer to price.

So when trading pullbacks or retracements, using EMAs would tend to make the market seem like it is “bouncing” off the EMAs.

With the SMAs, while you can do trade pullbacks with it, it isn’t as “sticky” as the EMA.

Hence EMAs would be better for our trading strategy.

The 50 EMA Bounce Trading Strategy

Now, I want to start off by saying that this setup doesn’t happen often but when it does, it works really well.

For this strategy, we are going to use the 20 EMA and 50 EMA.

We only want to take Long trades when the 20 EMA is above the 50 EMA.

And we only want to take Short trades when the 20 EMA is below the 50 EMA.

If you take a look at this chart below, you will see that the market has bounced off the EMAs several times.

However, there are more times where the market ignores the EMAs and just goes through them.

So how do we know when the market will bounce off the EMAs?

Unfortunately, that is a trick question.

We will never know when the market will bounce off the EMAs.

However, we can speculate when there might be a good probability of the market bouncing off the EMA  by seeing if the market has bounced off the EMAs before.

So first of all, we want to wait for a crossover of the EMAs.

Let’s take a look at a Long trade.

First, look for the 20 EMA to cross above the 50 EMA.

Once the 20 EMA has crossed above the 50 EMA, we want to look for the 1st bounce off the 50 EMA.

If the market didn’t bounce off the EMA and just went through it, then we want to wait until a bounce occurs before we consider that the 1st bounce.

In this chart above, the market just went through below the EMA without bouncing off the first time.

But the second time it touched the 50 EMA, it bounced off.

That will be considered the 1st bounce.

From there, we will be looking for the 2nd bounce to get into a Long trade.

Long Entry Criteria

Now that we have our 1st bounce off the 50 EMA, we are looking to go Long on the 2nd bounce.

However, we don’t want to go Long every time the market touches the 50 EMA after the 1st bounce.

That’s because it can still go through the EMA without bouncing off.

So we need to have a trade entry criteria to go Long.

To go Long on the 2nd bounce, we want to see 3 things happen:

1. A “hidden” divergence on the stochastic indicator.
2. A bullish candlestick pattern forming.
3. A close above the bullish candlestick pattern.

Let’s take a look at an example:

In the chart above, we have the 20 EMA just crossed over the 50 EMA.

Immediately after the EMA crossover, we have identified our 1st bounce.

Now that we have identified our 1st bounce, we now wait for a 2nd bounce.

Once the 2nd bounce has appeared, we look to the stochastic indicator to see if there is a hidden divergence.

As you can see, the market is making higher lows but the stochastic indicator is making lower lows.

This is a hidden divergence.

The next step is to wait for a bullish candlestick to form.

In the chart above, a Bullish Piercing Candlestick Pattern formed on the 2nd bounce.

To go Long, we wait for a close above the high of the Bullish Piercing Candlestick and we place our Stop Loss below the low of the previous swing low.

Our Take Profit level will be at 1.5R or 2R.

Short Entry Criteria

To enter into a Short trade, it is the opposite of a Long trade.

So to go Short on the 2nd bounce, we want to see 3 things happen:

1. A “hidden” divergence on the stochastic indicator.
2. A bearish candlestick pattern forming.
3. A close below the bullish candlestick pattern.

On the left-hand side of the chart above, you can see that the 20 EMA just crossed over the 50 EMA.

Once this happens, we will be looking for our 1st bounce.

After the EMAs crossed over, the market did go back up to the EMAs initially, but the EMAs weren’t respected.

It went above the EMAs, came back down, went back up again, then came back down again.

We do not consider this a bounce.

So at this point, we still want to look for our 1st bounce.

Several bars later, we have our 1st bounce.

After the 1st bounce, the market very quickly dropped down in one big candlestick bar.

And then it went back up again to the 50 EMA.

The market started to stall at the 50 EMA and then it formed a Bearish Pin Bar.

This was our signal to get ready to go Short once the market closes below the low of that Bearish Pin Bar.

However, the next few bars saw the market somewhat consolidating and not really making any move.

Finally, the market went lower and it closed below the low of the Bearish Pin Bar.

That is our trigger to go Short at the close of that bar.

Then we place our Stop Loss above the high of the previous swing high.

Some traders like to place their Stop Loss directly above the Bearish Pin Bar.

That is a viable Stop Loss area as well, but it’s very prone to Stop Loss hunting.

Because that’s the obvious place that people would place their Stop Loss.

Many times, the market will get you into the trade, only to go back to hit your Stop Loss which was very obviously placed above the high of the Bearish Pin Bar, and then go back down again.

In this case, it didn’t, but there are many times where it will.

By placing your Stop Loss above the previous swing high, it makes your Stop Loss harder to get hit.

And it is a place where if the market gets there, chances are that your trade isn’t going to work out anyways.

As for the Take Profit level, again either we place it at 1.5R or 2R.

If you’re wondering why only 1.5R or 2R?

The answer is because we have placed our Stop Loss pretty far away at the previous swing high.

That means our Stop Loss distance is pretty wide.

So the market may not necessarily go very far down from where we placed our 1.5R or 2R Take Profit level.

However, if you had placed your Stop Loss above the high of the Bearish Pin Bar, then you most likely can go for 3R and probably more because your Stop Loss is tight.

The tradeoff is that you will get stopped out more often compared to where I place my Stop Loss, but you can get bigger wins each time you Take Profit.

Ultimately, it all comes down to your trading style and psychology.

Do you like to get stopped out often but win big wins each time?

Or do you prefer to win more often but not get smaller wins each time?

There’s no right or wrong answer.

As long as you are profitable at the end of the day with a positive expectancy system, then that’s all that matters.

The Hidden Divergence EMA Trading Strategy

Now, what if you can’t always find a trade that bounces off the 50 EMA?

Does that mean you can’t get into a pullback trade?

Definitely not.

That’s where this strategy comes in.

So for the lack of a better name, I’ve called this the Hidden Divergence EMA Trading Strategy.

I know, I know…

The 50 EMA Bounce Trading Strategy also utilizes the hidden divergence.

But it has strict criteria whereby the market has to bounce off the 50 EMA.

For this EMA trading strategy, the setup is much easier to happen.

And the beauty of this trading strategy is that there’s no need to identify candlestick patterns.

Many traders get confused with the different candlestick patterns and miss their entries.

With this strategy, the trade entry criteria are more objective than subjective.

It’s also very similar to the 50 EMA bounce strategy where we will be using the stochastic indicator to identify hidden divergence.

The only difference is that we do not look at bounces off the 50 EMA, or any EMA for that matter.

Instead, we look for higher highs and higher lows in an uptrend, and lower lows and lower highs in a downtrend.

Long Entry Criteria

The very first thing we look for to get into a Long trade is that the 20 EMA must be above the 50 EMA.

Once we have that, we look for the following:

1. The market to make higher highs and higher lows.
2. Wait for the market to close below the 50 EMA.
3. Check the stochastic indicator for hidden divergence.
4. Wait for the market to close above the 20 EMA.
5. Go Long and place Stop Loss below the swing low.

 

In the chart above, the first thing to notice is that the 20 EMA was initially below the 50 EMA, but then it crossed above the 50 EMA.

So we are only looking for a Long trade once the 20 EMA has crossed above the 50 EMA.

On the left-hand side, you can see that the market moved from below the 50 EMA to above it and started to form higher highs and higher lows.

At the first higher low, we can see that although the market did go up some distance from that point, that was not a valid entry for us because the stochastic indicator is not showing a divergence.

So when there’s no trade signal, we sit on our hands patiently and wait for the next one.

As the market started to move higher, it formed a higher high and a second higher low.

At that point, what we want to look out for is for the market to close below the 50 EMA.

When the market did close below the 50 EMA, the stochastic indicator was also showing a hidden divergence.

The next step is to wait for the market to close above the 20 EMA.

Once it closes above the 20 EMA, go Long and place a Stop Loss either below the current swing low, or the previous swing low, depending on how far away it is.

If the previous swing low is quite a distance away, then I would place the Stop Loss below the current swing low.

Short Entry Criteria

Now that we know what the Long entry criteria is, the Short entry criteria is simply the opposite.

So here’s what you want to look for in a Short entry:

1. The market to make lower lows and lower highs.
2. Wait for the market to close above the 50 EMA.
3. Check the stochastic indicator for hidden divergence.
4. Wait for the market to close below the 20 EMA.
5. Go Short and place Stop Loss above the swing high.

In this chart, you can see that right after the 20 EMA crosses below the 50 EMA, the first lower high is formed.

Unlike in the Long entry example, there is a hidden divergence immediately formed at the first lower high.

The market then closed above the 50 EMA, and subsequently came back down to close below the 20 EMA.

This is our Short entry signal.

Once the candlestick below the 20 EMA closes, that is our Short entry.

Place Stop Loss above the current swing high.

Take profit is at 1.5R or 2R.

So there you go…

These are the two EMA trading strategies to trade pullbacks.

Pick Just One Trading Strategy

What I’ve presented to you here are two of the strategies I’ve been using for a long time to trade pullbacks.

But there are many different trading strategies out there that trade pullbacks as well.

Even just using EMAs, traders can come up with a multitude of EMA trading strategies.

Is there ONE best strategy to use?

NO.

But there is the best strategy that is suited for you.

Ultimately, it comes down to how comfortable you are with trading the strategy.

And whether you have the time and patience to trade the particular strategy.

Once you’ve found a trading strategy that you’re comfortable with, test it out before putting all your life savings into it.

Be a smart trader.

And make sure the trading strategy actually gives you an edge trading the markets.

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