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Monday, May 16, 2011

Moving average

Moving average is the topic of the post. I don’t intend to dive deeply into the topic, but rather concentrate more on application of the indicator. This is an indicator that helps you to define a trend in any given security and if the market is in a range it helps you to see what are possible support and resistance levels. This is a lagging indicator, because the values the indicator shows are based on past prices. It is not able to predict future action of any security or at least it is not meant to. In the article I will talk about simple moving averages, but I intend to discuss exponential moving averages in a few weeks time. 

How are moving averages calculated

Most often closing prices of securities are taking to define the value of a simple moving average. As each day new data is added you get an indicator that is really moving and changing based on the closing prices of a day.

Various periods for moving averages

A technical analyst will divide various time frames that moving averages can be used in. Those time frames may show short term trends, mid-term trends and long term trends. Short term trends can be defined by the direction of faster moving averages: 5-20 days. Mid-term trends are usually defined by mid-slow moving averages 21-50 days. And long-term trends are defined by slow moving averages 100-200 days. 

How does a moving average show a direction in a trend

First of all a trend in a security can be easily defined by simply looking at the price action. If the price is going up, the trend is upwards. If the price is moving down, the trend is downwards. In case of moving average, we can state that when a price is above the moving average and the average is going up we have an uptrend and if the moving average is above the price and is going down, we have a downtrend.  If the price often crosses moving averages upwards and downwards, we can say that a security is in a range. 

Look at bigger time frames first

When analyzing trends and action of various indicators you have to look at bigger time frames first in order to see if a price of a security is in a trend, range or simply moving sideways. By looking at bigger time frames you are able to see the big picture and identify the state a market is in at any given period of time. I consider monthly, daily and weekly time frames as long term, 4-8 hour time frames as mid-long and 15 minute to 1 hour frames as short term ones. 1 to 5 minute time frames can be used for scalping and are also quite good to define entrance levels. So, when you look at a daily chart and you see that a moving average is below the price and the direction of the average is up, you can make a conclusion that the trend of the security is upwards (same rules apply for identifying downtrend).  

Trading moving averages in a trend

One of the possibilities to use a moving average in a trend is to place a moving average (20 to 50) on a daily chart (assuming we are going upwards) and wait till the price reaches the moving average. Then you go long as moving average in a trend acts as a support level. Although, it is not a very reliable method, however it can be used combined with a few other trading styles. While searching for the place to enter a market in the direction of a trend you might want to look for oversold levels (if we still have in mind up trend). (Look at example with aud/usd daily chart and see how price touches 50 sma (red line), which acts as support)

My favorite usage of moving average

Most traders like using 200 sma or ema in defining a trend or trying to identify support and resistance. This average is still the most accurate on most time frames. I like watching at price action when a security approaches 200 sma on various time frames to see whether it will hold the price or not. If I start seeing a reversal pattern (123) combined with oversold levels on RSI indicator I definitely look for opportunities to trade a reversal. 

When moving average turns

Another opportunity to trade simple moving average is on long term charts (daily, weekly) when it turns (from rising to falling or from falling to rising). Again, as moving average is a lagging indicator you would be late for the trade (in most cases). You could try using faster moving averages (10-20 day moving average (crossovers)) for daily charts. I do not like this feature though. EMA’s are better for trading turns.
So much about moving averages. I hope to expand this post in the future to give you more examples and possibilities for trading them. 

Read my previous post:

Aud/usd and silver