Forex trading strategies range from very simple to very complex. A simple forex trading strategy based on technical analysis is the so-called “EMA crossover”. This strategy is easy to learn for beginning forex traders. For this strategy you use the technical analysis tool “exponential moving average” (EMA). This indicator allows you to identify trends in exchange rates. For the EMA crossover strategy, the main thing is to find a reversal of the trend.
Settings for the EMA crossover forex strategy
EMA means “Exponential Moving Average” and is a weighted average of the share price over the past periods. How many periods depends on how you use the EMA. The 13EMA is the weighted average of the past 13 periods. With “weighted” we mean that the most recent rates have a larger count than the older prices. In most software from forex brokers you can easily plot the EMA on the forex charts.
The EMA crossover strategy uses three different EMAs of the same currency pair, for example 5EMA, 13EMA, and 62EMA of the EUR / USD. Based on the intersections (crossovers) of these different EMAs there is a trend change and a buy signal is generated.
The starting situation must be such that (for a long position), the current value of the 5EMA is below the value of the 13EMA, and the 13EMA is below the 62EMA. This means that the currency pair was in a downward trend (the short-term average is indeed lower than the long-term average). If the 5EMA now moves up and crosses the 13EMA and then the 62EMA, this is an indication that the trend is reversing. The short-term average increases through the medium-term average, and then through the long-term average. The trend now is going up which is a buy signal to go long.
This forex strategy also works the other way; if you want to open a short position. Then there must have been an upward trend after which a sell signal is created when the 5EMA first drops below the 13 EMA and then below the 62EMA. Please note that you only get in if the candle of the last period is closed and the short-term EMA is above (or below for a short trade) the long-term EMA is. Otherwise there is a risk that the EMA was merely touched but no new trend had started.
EMA crossover strategy in practice
The forex chart below illustrates how to detect a buy signal with this strategy. You can create such a chart yourself with the software of a forex broker, for example, Markets.com. Open the hourly chart of a currency pair of your choice and choose among the technical analysis tools the “exponential moving average” with a period of 5, 13 and 62.
This chart is an hourly forex chart of the GBP / USD with EMA 5 (yellow), 13 (red) and 62 (blue). At the first arrow you see a downward 5-13 EMA crossing, but because there is no 5-62 crossing we cannot speak of a trend reversal. Shortly afterwards you see that the price bounces back up again. At the second arrow there is another downward 5-13 crossover, however, this time followed by an 5-62 crossover(third arrow). Once the candle is closed after the crossover (fourth arrow) you open a short position. You will a part of the profit, but it prevents you from trading on an unreliable signal.
You keep your forex short position open until the 5EMA rises above the 13EMA again (fifth arrow): the trend is ending. Additionally, there might be a buy signal for a long trade ahead, so keep your eye on the forex chart for a 5-62 crossover. This indeed occurs (sixth arrow) and when the candle is closed (seventh arrow) you open the trade. By the end of the chart you see that the 13EMA has almost caught up with the 5EMA again. If the two indicators touch each other you can officially consider it a signal to close the long position.
You see, the price has both gone up and down over a period of several hours. And the great thing about this, is that you have to opportunities to make profitable trades using the EMA crossover forex strategy: first by opening a short position on the downward reversal of the trend and second by opening a long position on the upward reversal of the trend.
How do you choose the correct time frames for the EMA? It is important that the selected time frames are a good reflection of the short, medium, and long term. A popular setup is the 5-13-62 EMA crossover. Another common setup is the 3-20-65 EMA crossover. Make sure the EMA’s are not too close to each other. Since the recent periods are weighted much more heavily in the EMA, the difference between, for example, the 60EMA and the 70EMA is very small. This gives too much noise and therefore false buy signals.
Now should you apply this strategy to the 5-minute, 1-hour, daily, weekly or any other forex chart? Basically, this trading strategy can be applied to all time horizons. However, it works best in a market with clear up-and-down fluctuations: a ranging market. This is most common for the 15-minute and 1-hour charts. Shorter time frames contain too much micro fluctuations, while in longer time frames the fluctuations are often too slow to benefit from.
Important to realize is that the EMA indicators are “lagging”. That means they cannot predict what a price is going to in the future but only to summarize what it has done in the past. So if the 5EMA crosses the 13 EMA in upwards direction, it only means that the price of the currency pair has gone up over the last period and has exceeded the moving average. There is no guarantee that this movement will continue.
The assumption this strategy makes is that once a trend reversal has occurred, it will continue to move in the direction of the new trend, at least until the next support or resistance level, or Fibonacci level. In fact, you conclude that the EMA crossover has caused a new trend to emerge, and that this is sufficient evidence for a continued trend reversal.
Stop loss and take profit
This assumption is not correct in 100% of the cases. Sometimes, the buy signal is false and the crossover was caused by a micro fluctuation. Therefore, it is important to set a good stop loss. A suitable stop loss is when the short-term EMA changes direction and again crosses the long-term EMA. That is seen as a sign that the trend reversal will not continue. Do not close the position until the candle of the last period is closed. That prevents you from unnecessarily closing your position due to noise. Note that with this type of stop loss it cannot be determined in advance at which price to place the stop, so make sure that you actively monitor your trades.
The new trend will not continue infinitely, so it’s also important to think about how much profit you want to make before closing the position. In a ranging market it is wise to put your take profit at least at (or just before) an accepted resistance level. If there is none, you can also look at the next Fibonacci level. It often acts as resistance.
It might also happen that the prices does not continues to rise to your take profit, but flattens or reversed direction somewhere halfway. At a given point, the medium EMA will then reach the same level as the short EMA again. If the medium-term EMA touches the short-term EMA again, this is a sign that the trend is weakening and you better close the position. This strategy thus requires some active monitoring. But if you choose the EMAs well and monitor your trades closely, it can be very profitable!
This article is part of the “Forex technical analysis strategies for advanced traders” series. Continue reading the next article “Bollinger Bands technical analysis“