The 10 and 21 EMA Crossover Strategy

The 10 and 21 EMA Crossover is a simple moving average crossover strategy. It is part of a broader spectrum of trend following systems that aim to capitalize on substantial one sided moves in financial markets.

The Entry

The entry of the system is very simple. A long signal is generated when the 10 Exponential Moving Average crosses over the 21 Exponential Moving Average. On the opposite side of the spectrum, a short is initiated when the 10 EMA crosses below the 21 EMA. The chart below shows an application of the 10 and 21 exponential moving averages on a 1 Hour EUR/JPY chart.

There are differences between traders on the application of the EMAs. Some wait until the bar closes and only take a signal if the cross is still present at the time of the close. Others prefer to watch the market live and enter whenever a crossover appears without waiting for a bar close. The signals generated by waiting for the bar’s close will tend to be slower and thus less volatile. Slower technical analysis tools tend to perform better during slow and steady trends.

The Stoploss

The stoploss for this system is usually a crossover in the opposite direction with a disaster stoploss placed ‘’just in case’’. If we’re long, we would wait for the 10 EMA to cross back below the 21 EMA and we would exit our trade when that happens. Again there is a difference between those that wait for the close of the bar and those that prefer to get out right away. Because waiting for an EMA cross to occur and trading without a stoploss in not a good idea, most traders will place a ‘’disaster stoploss’’ on their trade ‘’just in case’’.

How big of a disaster stoploss you use is up to you. A good way to find a good value for the stop is to go back in time for your chosen trading system and explore what is known as the MAE (Maximum Adverse Excursion). The MAE shows the maximum drawdown experienced during the life of trade. Let me illustrate this with an example.

Let’s say that you go long the AUD/USD at 1.0050. After you enter, the Aussie goes south, trades all the way down to a low of 1.0013 before retracing and closing the bar giving us an exit at 1.0040. Here the net result of our trade was – 10 pips but our MAE (Maximum Adverse Excursion) was 37 pips (1.0050 – 1.0013). In order to find a good value for a disaster stoploss, go back in time and see what is the drawdown tipping point above which most trades end up losing. For example, if by going back in time and writing down the MAE of each trade you find that a trade that has passed 100 pips in drawdown rarely ‘’comes back’’ into profit territory, you could place your stoploss at 100 pips. Placing a stoploss, even if it is only a disaster stop, would also allow you to properly calculate your risk per trade.

Take Profit

The take profit signal is as simple as the entry. We wait for a crossover in the opposite direction. In we’re long, we will be looking for a crossover of the 10 Exponential Moving Average below the 21 EMA. For a short trade, we would take our profit when the 10 EMA goes back above the 21 period moving average.

While the exit is relatively straightforward, a lot of traders will have a hard time following it. Most people are wired to let losses accumulate but will cut winning trades short. Taking the profit and holding onto your winning trades is the most important part of a trend following system. Botching the entry is nowhere near as damaging to your bottom line as cutting a winner short. If you decide to trade trend following strategies like the 10 and 21 moving average crossover, you have to be willing to let winners ride. Most of your profits will come from a small number of trades and it is vitally important to not get in the way of this. As the famous market speculator Jesse Livermore said in ‘’Reminiscences of a Stock Operator’’, what made him money was his sitting tight: ‘’It never was my thinking that made the big money for me. It always was my sitting.’’

Modifications of the 10 and 21 EMA Strategy

Forex is one of the financial markets that has been most affected by the mean reversion effect since 2008. The Currency Wars launched in the aftermath of the 2008 financial crisis (see Currency Wars in a Post 2008 World for more) lead to most majors trading without a significant sustained trend. Nowhere has this been more obvious than in the EUR/USD. After the Euro Debt Crisis calmed down in the summer of 2012, the currency pair has been going nowhere fast. The Daily EUR/USD chart below shows the 10 EMA in red and the 21 EMA in green. We can see that as the currency pair moved back and forth the two MAs crossover back and forth resulting in several substantial losses in a row. The 3 small wins in between weren’t enough to offset the losses and resulted in a losing year for the system in 2013.

When systems stop performing traders usually respond by modifying them in some way. One of the most common mods to the 10/21 EMA crossover strategy is to include the RSI (Relative Strength Index) into the mix. Common RSI settings include the 14 and 21 RSI. The Relative Strength Index is mostly added when trading the lower timeframe charts like the 1 hour or lower. The 1 hour EUR/USD chart shows an example of this trading setup.

A long signal is initiated when the 10 EMA goes above the 21 EMA. At the same time, the RSI has to print above the 50 mark, or already be above the 50 mark at the time when the EMA crossover occurs. For a short, the 10 EMA has to go below the 21 EMA and the RSI has to cross the 50 line, or already be below the 50 line when the short signal occurs.

The problem with using this trading setup on the lower timeframe charts is that the lower you go in TFs, the harder it becomes to make money with mechanical trend following systems. Trading experience and entry picking become the dominant factor when trading below the 4 Hour chart. If you’re new to trading, using this entry technique on anything lower then 4H is not recommended. Stick to the higher timeframe charts until you gain more trading experience.

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