Moving Averages

The first indicator we will study is perhaps the most basic. The moving average is simply an average of price across a given time frame. The technical trader is aided in his decision making by using moving averages to help determine both the direction of the trend as well as the strength of a given trend. There are several types of averages such as exponential, triple-weighted, adaptive, and zero-lag moving averages, but the conceptual theory and application remains the same. In the following examples, a simple moving average will be used.

The Mathematics

There are many different types of moving averages which a trader may choose to use. The most basic form of a moving average is the simple moving average. The simple moving average is an equally-weighted average of price across a given time frame. This means that if a trader were to calculate a simple moving average by hand, he would add up all of the closing prices and divide by the period of his moving average. As a new candle is formed, he would remove the last price from the average and add in the most recent. As price increases, the moving average will increase and as price decreases, the moving average will decrease.

The Most Appropriate Average

When a trader decides to add moving average to his arsenal of tools, he must determine which period of moving average he will use. This is largely determined by personal preference, but the averages chosen must be reasonable and make sense. For example, a trader looking to catch very small scalp moves on his chart would be better suited with a 10 period moving average rather than a 200 period moving average. Additionally, for a trader looking for a longer-term trade, a 200 or even 250 period averages may be appropriate for him. Also, when a trader is attempting to determine which type of average he should employ, it is important that he remember that the concept behind all moving averages is the same: they reflect the trend. For a trader struggling with the decision of averaging method, perhaps the easiest method to understand is the best. A simple or an exponential average (one which smoothes by weighting different time periods differently) is suited to most traders? needs.

Moving Averages

An Important Note

For a trader who wishes to use moving averages in his trading plan, there are several key features regarding a moving average of which he must be aware. The moving average is a lagging indicator. This means that what a trader sees in a moving average has already occurred in the price. For example, if the price were to break out of a trading range, the moving averages would take some time to respond the new trend. Another detriment to moving averages is that they are trend following indicators. The purpose of moving averages is to help a trader determine if a trend is in existence. While price is trading within a range, a moving average is of little value to the technical analyst.

Laggy Moving Averages

Below we have included some of the most popular and successful strategies which traders frequently use.

Method 1 - Price Breaks the Average

The most basic moving average trading strategy is one in which price breaks above or below the average generating a buy or sell signal. The theory behind this strategy is based on the idea that prices tend to trend and a trend once it is in motion will tend to stay in motion. When price is above a moving average, it is by definition increasing. The key to profiting with this type of strategy is to factor in price action to ensure that a trade is initiated at the correct moment. For a trader using this method, he must initiate his trades when price is in a clearly defined trend or retracement. A trader wishing to profit when price breaks above its moving average must factor in key support and resistance levels to ensure that price is indeed trending and not within a trading range.

Laggy Moving Averages

Summary ? To trade a Price Break of a Moving Average:
1. Draw key support and resistance areas as well as trend lines.
2. Determine that price is trending and not within a trading range.
3. Purchase when price breaks above the moving average or sell when price breaks below it.
4. Set initial stop below the immediate prior retracement.
5. Exit as soon as price falls back below the moving average or a stop is hit.
6. Never trade against the primary trend.

Method 2 - Moving Average as Support or Resistance

Another strategy which is often successfully employed is the method of using moving averages as support and resistance. As price travels in a trend, it frequently finds support or resistance at either a trend line or a key moving average. If a trader is using an appropriate moving average, he may be able to initiate a trade in the direction of the trend with a relatively small degree of risk. In practice, this type of strategy is very simple. A trade will monitor a security which is trending and he will place a trade as soon as the price retraces into the moving average with the expectation of price rebounding off of the moving average and continuing its trend. Should a trader be incorrect, this method allows the trade the opportunity to have a fairly tight stop-loss order to preserve his capital.

Moving average support

Summary ? To Trade a Support or Resistance Moving Average
1. Wait for a security to be in an established trend.
2. Draw key trend lines and wait for price to form a retracement.
3. When price nears the moving average, initiate a trade in the direction of the trend.
4. Set initial stop a short distance beyond the moving average.
5. Move stops to prior retracements as the trend resumes its direction.
6. Never trade against the primary trend.

Method 3 - Moving Average Crossover

One of the most visually appealing trading strategies is a moving average crossover. With a moving average crossover strategy, a trader almost entirely ignores price and trades purely based on moving averages and how they relate to each other. With a moving average crossover strategy, when a shorter period moving average is above a longer period moving average, the price is trending upwards. When a longer period moving average is above a shorter period moving average, price is trending downwards. A trader seeking to initiate a moving average crossover trade would open a position as soon as the moving averages cross over each other and exit the trade the moving averages cross back over. In order to properly use a moving average crossover system, a trader must first draw key support and resistance zones so that he can determine if a trade is within a trading range or if it is already trending. The best moment to initiate a trade based on a crossover is when the moving averages cross within a prolonged retracement inside of a trend. Another excellent moment is to monitor a moving average crossover if it occurs inside of a trading range and trade as soon as it clears the range in the expected direction.

Moving average crossover

Summary ? To Trade a Moving Average Crossover
1. Draw key support and resistance levels to determine if price is trending or in a trading range
2. If price is already trending, wait for a retracement to enter the trade and enter based on a moving average crossover.
3. If price is in a trading range, wait until price breaks out of the range before initiating a trading the direction of the trend.
4. Set the first stop below a prior retracement or exit as soon as the averages cross back over each other.
5. Move stops to prior retracements as the trend resumes its direction.
6. Never trade against the primary trend.