10/20 EMA (Exponential Moving Averages)
Learn to use moving averages as dynamic stop-loss levels and trend confirmation tools to manage positions effectively in different market conditions
Moving averages are versatile tools that provide valuable insights into a stock’s trend and serve as dynamic stop-loss levels. The 10-day and 20-day exponential moving averages (EMAs) are particularly effective in trending markets, allowing traders to stay in winning trades while protecting gains. However, their relevance depends on the stock’s behavior and market conditions.
This lesson focuses on how to incorporate moving averages into your stop-loss strategy, adapt them to different trading scenarios, and recognize signals that indicate when it’s time to exit.
Learning Objectives
By the end of this lesson, you will be able to:
- Understand the role of 10-period and 20-period moving averages in trend following
- Use moving averages as a stop-loss reference to manage risk
- Identify when a stock respects a specific moving average and adjust accordingly
- Recognize trend exhaustion and signals for potential exits
- Apply this strategy in different market conditions (trending vs. choppy)
The Role of the 10- and 20-Period Moving Averages
The 10 EMA and 20 EMA are commonly used in trend-following strategies. They serve as a guide for how a stock moves and can provide insight into price strength confirmation.
- The 10 EMA is often respected in strong trending stocks, where price pulls back briefly before resuming its move
- The 20 EMA is used when stocks move at a slower pace, allowing for deeper pullbacks without breaking the trend
- As a stock trends, tracking which moving average it respects helps in position management and stop-loss adjustments
Example: Nvidia Trend
Nvidia recently trended up the 10 EMA for weeks, showing strong momentum before eventually breaking below it, signaling a potential exit.
Using Moving Averages as Stop-Loss References
Moving averages are not absolute stop-loss levels but serve as guidelines to help traders manage risk and maximize gains.
- Initially, traders should use standard stop-loss rules rather than relying on moving averages
- As a stock respects a moving average multiple times, that moving average becomes more significant
- The “Two to Three Touches Rule” suggests that after two to three successful tests of an EMA, a breakdown below it could trigger increased selling
- If a stock fails to hold the 20 EMA, it may indicate trend exhaustion, prompting an exit
Example: EMA Respect Pattern
If a stock touches the 10 EMA once but later shows stronger respect for the 20 EMA, traders should adjust expectations and manage the trade accordingly.
Identifying Trend Exhaustion and Exit Signals
Stocks often provide warning signs before breaking a key moving average. Recognizing these signals allows traders to exit before major losses.
- Failed Breakouts: A stock gaps up but fails to follow through, indicating a loss of buying momentum
- Outside Reversal Days: When a stock trades above the prior day’s high but closes below its low, signaling a shift in sentiment
- Gap and Trap Patterns: A stock opens higher but sells off immediately, suggesting sellers are in control
- Three Bar Break Pattern: A large bearish candle engulfs the price action of the previous three bars, marking a key character change
Example: Nvidia Warning Signs
Nvidia showed multiple warning signs, including outside reversal days and a failed breakout, before finally breaking the 10 EMA, confirming trend weakness.
Adjusting to Market Conditions
The effectiveness of moving averages as stop-loss references depends on the overall market environment.
- In Trending Markets:
- Stocks respect moving averages and trend higher over extended periods
- Pullbacks to the 10 EMA or 20 EMA present buying opportunities
- The moving averages provide clear stop-loss levels
- In Choppy Markets:
- Stocks frequently break moving averages without following through
- False breakouts and sharp reversals are common
- Moving averages lose reliability as indicators
Example: Choppy Market Conditions
In a choppy market, stocks frequently dip below moving averages before bouncing back, making stop-loss placement more challenging.
Deciding When to Exit Based on Moving Averages
- The seven-week hold rule, as outlined in “Trade Like an O’Neil Disciple,” suggests that after a stock holds the 10 MA for seven weeks, breaking below it signals an exit
- Discretionary exits: If multiple warning signals appear, traders can exit before a moving average is officially broken
- Waiting for the end of the day: In most cases, waiting until the close to confirm a break of the moving average can prevent premature exits
Example: Seven-Week Rule
If a stock has respected the 10 MA for seven weeks and then closes below it, traders should exit, as historical testing suggests the trend is weakening.
Reflection
Do you recognize patterns where stocks repeatedly respect a certain moving average before breaking down?
Conclusion
The 10-period and 20-period exponential moving averages provide traders with a structured way to identify trend strength, stop-loss levels, and potential exit points. They work best in trending markets, where stocks tend to respect these levels. However, in choppy conditions, relying solely on moving averages can lead to false signals. Understanding when a stock is respecting a specific moving average and combining that with trend exhaustion signals can help traders make informed exit decisions.
Action Items
- Review past trades and check how stocks behaved around the 10 EMA and 20 EMA
- Monitor stocks in real-time to see which moving averages they respect over time
- Adjust stop-loss strategies based on whether a stock holds the 10 EMA or 20 EMA
- Recognize warning signs such as outside reversals, failed breakouts, and three-bar break patterns