The Magic of 50EMA - The Educated Analyst

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The Magic of 50EMA Written by Biplab Bhattacharya Thursday, 14 April 2011 00:00

When the going is good, everybody makes money. Whether it is the hot-shot fund manager, or some common investor buying stocks based on recommendations doled out by the so-called experts in the business channels. However when the market turns it does give investors like me sleepless nights, or least to say a very negative feeling, as I see my portfolio balance depreciate rather faster than I can say SELL. More so, whether I earn or not my broker or my mutual fund manager does always earn. Whenever I offload the stocks which were recommended to me by my broker I pay a brokerage, and the expense ratio or fund management charges of the fund is built into the net asset value (NAV). Is there a simple tool which can guide investors like me stay on the correct side of the market, and help make buy or sell decisions without the aid of financial experts? The 50EMA (exponential moving average) line combined with some simple filters helps me achieve exactly that. It surely does not have the glory of complex mathematical formulae or chart structures, but it works, which is what I am interested in. The 50EMA is a moving average of the last 50 closing prices with maximum weights on the recent prices and minimum on the earlier, however weights never reaching zero. Hence it smoothens out the price volatility. The 50EMA gives clear signals in a trending market and an investor can buy or sell easily when prices cross above the 50EMA line or below it. One needs to ensure that on crossover the closing price is higher than the open, or that the candle formed is bullish. This is the daily chart of NASDAQ starting 3rd week of May 2009 till 2nd week of March 2011:

(Click on image to enlarge)

The red circles on the chart are the points where prices have crossed the 50EMA from below, generating a BUY signal. During this time frame of 454 days, the 50EMA generated six BUY signals.

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The Magic of 50EMA - The Educated Analyst

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However, only four BUY signals numbered 1,2,3,6 generated profits. The remaining two signals, 4&5, resulted in losses. This is primarily because during both these signals the market was rangebound or in an intermediate correction. As I have mentioned earlier, this strategy works when the markets are in a trend. When the going is good, everybody makes money. Whether it is the hot-shot fund manager, or some common investor buying stocks based on recommendations doled out by the so-called experts in the business channels. However when the market turns it does give investors like me sleepless nights, or least to say a very negative feeling, as I see my portfolio balance depreciate rather faster than I can say SELL. More so, whether I earn or not my broker or my mutual fund manager does always earn. Whenever I offload the stocks which were recommended to me by my broker I pay a brokerage, and the expense ratio or fund management charges of the fund is built into the net asset value (NAV). Is there a simple tool which can guide investors like me stay on the correct side of the market, and help make buy or sell decisions without the aid of financial experts? The 50EMA (exponential moving average) line combined with some simple filters helps me achieve exactly that. It surely does not have the glory of complex mathematical formulae or chart structures, but it works, which is what I am interested in. The 50EMA is a moving average of the last 50 closing prices with maximum weights on the recent prices and minimum on the earlier, however weights never reaching zero. Hence it smoothens out the price volatility. The 50EMA gives clear signals in a trending market and an investor can buy or sell easily when prices cross above the 50EMA line or below it. One needs to ensure that on crossover the closing price is higher than the open, or that the candle formed is bullish. This is the daily chart of NASDAQ starting 3rd week of May 2009 till 2nd week of March 2011: The red circles on the chart are the points where prices have crossed the 50EMA from below, generating a BUY signal. During this time frame of 454 days, the 50EMA generated six BUY signals. However, only four BUY signals numbered 1,2,3,6 generated profits. The remaining two signals, 4&5, resulted in losses. This is primarily because during both these signals the market was rangebound or in an intermediate correction. As I have mentioned earlier, this strategy works when the markets are in a trend. Is there any way to avoid scenarios like 4&5? One way could be to watch out for the slope of the 50EMA line. Never buy when the slope is negative, although that would be a crude way of risking money. A better way would be to add a filter like MACD (moving average convergence divergence). I prefer the histogram, and a few ground rules for BUY signal: a) Price crosses over the 50EMA line on a bullish candle.

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The Magic of 50EMA - The Educated Analyst

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b) MACD is positive (or not negative, which means a zero value is valid). c) The MACD is in positive territory for less than 6 days. Lets apply these rules to scenario 4&5.

(Click on image to enlarge)

In scenario 4, the MACD is negative, and in scenario 5 the MACD is positive for more than 6 days. Thus the rules do not allow any investment in scenario 4&5. The same rules allow for investment in scenario 1,2,3&6. Hence these simple rules help the investor stay on the correct side of the market. MACD is the difference between the 26 day and 12 day EMA, and the signal line is a 9 day EMA of this difference. The MACD histogram is the difference between the MACD and the 9 day EMA of the MACD. This makes the MACD a trend following indicator and also a momentum indicator. The third rule of entering a trade only if MACD is in positive territory for less than 6 days is basis observation over a long enough period of time. This ensures that the investor gets less whipsaws. These are the simple rules I use to aid my own trading decisions, and in sharing them with you I believe they will assist you in keeping your trades on the right side of the market.

BIPLAB BHATTACHARYA -

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The Magic of 50EMA - The Educated Analyst

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Biplab is a banking professional with 12+ years of experience, leading sales and distribution initiatives within Multi-national Banks.
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