When stocks start bouncing after a strong downtrend, how do you know when it’s safe to get back in the water? The 20-day EMA will show you the way! Here’s how…
When putting together a winning trading system, knowing which stocks to buy is an important piece of the puzzle.
However, knowing exactly when to buy may be even more important!
When should you be in “SOH mode” (sitting on hands) and mostly in cash?
When should you step on the gas pedal with more trades and larger position size?
Your level of consistent, long-term success as a stock trader or investor closely depends on knowing the answers.
CONTINUE READING to discover how the powerful 20-day EMA can show you the way!
Market timing: Staying safe in a weak market
The Nasdaq is currently down 27% year-to-date and has surrendered all of last year’s big gains.
But during this same period, The Wagner Daily portfolio is only down 4%.
Currently 100% in cash, the portfolio is also poised to start racking up explosive gains.
This is the result of following a simple, rule-based market timing system that revolves around one key indicator: the 20-day exponential moving average (20-day EMA).
Why the 20-day EMA?
We have shared our proven swing trading system with thousands of traders since 2002.
Throughout, we regularly emphasize the importance of a simple trading strategy that can easily and effectively be implemented.
To avoid analysis paralysis, the Morpheus trading system focuses on reliable chart patterns, relative strength, and a few basic technical indicators such as volume and moving averages.
When it comes to the market timing element of our trading system, it’s all about the 20-day EMA!
Although we also plot other moving averages on the daily chart, there’s just something about the 20-period moving average that simply works.
The time frame is not too short (10-day MA), nor too long (50-day MA) for reliable swing trade signals.
Much like Goldilocks discovering porridge of the perfect temperature, the 20-day moving average time frame is just right!
How it works: Putting the 20-day EMA into play
We apply the 20-day exponential moving average to daily charts of major indexes such as the Nasdaq or S&P 500.
The basic premise is this:
We increase market exposure when the price of an index is above the 20-day EMA, but quickly shift to mostly cash when it falls below the 20-day EMA.
When the Nasdaq or S&P 500 is trending lower (series of lower highs and lower lows) and below a declining 20-day EMA. there simply isn’t much to do on the long side of the market.
But when the price eventually bottoms out and bounces above its 20-day EMA, that’s when it’s time to pay close attention!
When an index starts bouncing off its lows, we first look for the price to close above its 20-day EMA, then push higher within the next one to two days.
However, there is a bit more to it than blindly buying stocks when an index moves above its 20-day EMA.
Rather, there are a few key requirements to prevent false buy signals.
Let’s look at a daily chart of the S&P 500 during its 2018 correction that led to a bullish reversal in early 2019:
Avoding false buy signals
Above, notice the first two moves above the 20-day EMA only held above the moving average for three to four days before stalling and reversing sharply lower.
Although the price reclaimed the 20-day EMA, there were a few key factors that led to a false buy signal:
- The 20-day EMA was not yet rising (it was sideways at the time)
- The S&P 500 price ran into resistance of its prior swing high (from October 2018)
- The 5-day MA (not shown) failed to cross above the 20-day EMA
Again, the basic premise of the 20-day EMA signal is simple, but the factors above must be considered to increase the odds of success.
Further, even if all the signals are perfectly aligned, it’s note we still start with small risk exposure and gradually increase as we build on successful trades.
When there is a false buy signal, losses are small because our Wagner Daily portfolio exposure remains light.
Third time’s a charm: 20-day EMA confirmation
On the same chart above, notice the third cross above the 20-day EMA (early 2019) was a charm.
Unlike the first two attempts, notice the price action held above the 20-day EMA for several days and then rallied to a higher high (rather than stalling lower).
Furthermore, notice how this time the 20-day EMA had already started rising.
The 5-day MA (not shown) had also crossed above the 20-day EMA.
The price holding above the 20-day EMA and continuing to push higher was our signal to gradually increase long exposure as new swing trade setups emerged.
How the 20-day EMA signal has worked in the 2022 bear market
Since the major indices are currently in a downtrend, let’s look at how the trusty 20-day EMA guide played has played out in the current 2022 bear market:
After a nasty plunge in January 2022, the bounce in early February led to two attempts to reclaim the 20-day EMA–but both quickly failed within a day or two.
With both attempts, notice the 20-day EMA was still trending sideways to lower (not rising).
Also, the 5-day MA never crossed above the 20-day EMA.
Again, even if we decided to enter any new swing trades at that time, our initial risk exposure would have been minimal.
But in mid-March, the price blasted through the 20-day EMA and broke out above a prior swing high.
The 20-day EMA was also rising, while the 5-day MA had crossed above the 20-day EMA.
This led to a valid buying window of several weeks before the price fell below the 20-day EMA again.
Exactly how much exposure to take during this period would have depended on your trading system and the number of quality buy setups with proper, low-risk entry points available.
When the price broke back below the 20-day EMA in early April, it was a warning sign to proactively raise stops and/or lock in profits on any positions (if not already done so along the way).
The beauty of a simple trading system
An ideal trading system is one with proven results and can easily be followed on a consistent basis.
The more complex a trading strategy, the greater the chance of making mistakes and not effectively applying it.
That’s why we love the 20-day exponential as a powerful way to determine when it’s time to start buying stocks again after a sharp correction.
Additionally, the 20-day EMA is a highly effective signal that can be applied to The Wagner Daily trading strategy or your own, existing trading system.
Ideally, use the 20-day EMA strategy with market indexes as your guide for timing buy setups in individual stocks.
If the Nasdaq or S&P 500 reclaims its 20-day EMA in the near-term and new buy setups start emerging, we will immediately start swing trading stocks with more exposure on the long side.
However, minimal follow-through in new buys, followed by an index breaking below its 20-day EMA, would promply force us to reduce exposure or go to cash.
Remember to trade what you see, not what you think!