Using Moving Averages In Your Trading
Moving averages are widely recognized as one the most important trading indicators. They are available across all trading platforms and are employed in most successful trading strategies. Understanding moving averages and how they can help your trading is of paramount importance.
Moving average is a technical indicator that helps to smooth out the price action. It simply shows the average price between certain periods. For example, if you are using a daily chart with 200 MA, the line will represent the average price in the last 200 days. If you are using an hour chart with 10 MA, the line will represent the average price in the last 10 hours. There are two types of Moving Averages:
- Simple Moving Average (SMA) – averge is calculated normally
- Exponential Moving Average (EMA) – average is calculated with bias towards more recent prices.
Since EMAs tend to be more sensitive to recent price changes, they are more commonly used than SMAs.
Why is trading Moving Averages so popular?
Moving averages are very versatile trading tools and although they are lagging indicators (meaning they lag behind the actual price action) they are used in several ways to the benefit of the trader. Moving averages are used for the following:
- Determining the direction of the trend
- Generating Buy/Sell signals on moving average crossovers
- Finding price support and resistance levels
- Trailing stop losses (n/a binary options)
Using MAs to determine the direction of the trend
Most professional long term traders use the 200 MA on a daily chart as their main trend indicator. Establishing the trend can be quite straightforward. If the price action is above the 200 MA line, it is in an uptrend, if it is below, it’s in a downtrend.
Some traders will prefer to use different settings, for example they will use a 50 MA to establish smaller trends. Traders can also use two MA lines, for example a slower MA of 200 and faster MA of 50 to establish a trend with each crossover of the faster MA . So when the 50 MA crosses above the 200 MA we say that the trend is up. (See picture below.)
Buy/Sell signals on moving average crossovers
Using two moving averages of different periods will produce buy/sell signals at each crossover. As we mentioned above, if you use a faster MA with a slower MA these lines will cross and each time they do it is a potential buy/sell signal.
There are hundreds of books written on the subject of moving averages and crossovers. Traders all over the world argue and can not agree as to what is the perfect MAs setting for crossover signals. Known as the Golden Cross.
Recent interview on Forbes with a top trader Jim Rohrbach admits that all he really looks at beside the price action is the 15/30 MA crossover.
But I’m telling you, and don’t tell anyone this one, Kate: A 15/30 crossover is all you need, or a 10/20 depending on how quick you want to get out.
Using fast MAs will produce more signals than when you use slower MAs. If you use a 15 MA and a 30 MA on a 5 minute chart you will have many signals a day, but it would be risky to trade on all of them. While the Golden Cross has not yet been formally established, there were many tests done by trading companies which tried to establish this by the use of automated trading robots.
The tests by ETE HQ revealed that the best (Golden Cross) MA settings within the tested period of time, which is important to indicate, were 10 MA and 50 MA (both Exponential). Here is a full result of the test:
A lot could be said about the various sets of crossovers but in the end the best settings will be those that you can work with to produce acceptable results.
If you want to trade MA crossovers and follow trends using the Meta Trader platform have a look at MT4 Trend Indicator. It is fully customizable and includes a very helpful and powerful Smart Display with additional market information that will be useful to any trader.
In addition it can generate and send BUY/SELL signals based on crossovers. It is by far one of the best trend following indicators for Meta Trader 4 platform we’ve seen. You can read review of it here description of the indicator here
Finding support and resistance levels
Moving averages can also be used as support and resistance lines. For example, if a price action is approaching and touching the generally respected 200 moving average, it is likely to get noticeable resistance and/or support at those levels. The MA support and resistance levels are often successfully used in binary options 30 to 60 second trades. In the example below you can see the resistance levels on the 50 Exponential Moving Average.
Trailing stop losses (does not apply to binary options)
Stop losses are used in forex and stock trading. Setting stop losses allows traders to control the loss amount of each trade. Stop losses are often set by price levels or in amounts. For example, if you’re trading $100 you could place a stop loss to – $10. So if the trade goes against your prediction and reaches a loss of $10 it will automatically close and you end up losing only $10.
A trailing stop loss is an intelligent algorithm which moves the initially set stop loss with the trending price. If your prediction is correct and the market follows the trailing stop follows also with a set distance from the price action. This way your trade is protected from a possible loss if the trend reversed.
Depending on the trade system, moving averages can be used for setting stop loss levels. The 13 MA and 20 MA are widely used for this purposes but it’s really up to the individual trader to test what works best in his/her trading system.
Unfortunately, in binary options there is no possibility to set stop losses on individual trades. Some brokers offer what they call a ‘stop loss’ on your trading account, but it only means that your entire deposited capital has a stop loss, which is not the same.Published in Education