Trading Moving Averages

As traders, we have many things to take into consideration. We have to implement many different factors and indicators in our analysis in order to succeed in this business, regardless of if you trade short or long term. These can include fundamental indicators, technical indicators, or both.

 

 

On the other hand, we shouldn´t overcrowd the charts with too many indicators that will contradict each other and cloud our judgment. I have seen many traders, especially new ones, that overload their charts with all sorts of lines and indicators, that then become a burden for traders instead of helping them. When looking at these charts you don´t really know what you´re looking at, they look more like matrixes from the future.

We shouldn´t complicate trading more than it already is. Charts should be easily understandable and the indicators should be simple to interpret. Simple indicators work better because more traders use them, increasing the possibility that trades based on these indicators will go the right way.

One of the simplest indicators is the moving average (MA). It is easy to interpret and can be placed on the chart so you don´t have to make calculations. You just wait until the price gets close to it and then decide whether to buy or sell. They act as cushions for the price, providing support and resistance.

There are four types of moving averages; simple, smoothed, exponential and linear weighted. You don´t have to guess what moving average to use, you just look at the chart history and see which ones have worked best in the past, that´s what makes the moving average strategy so easy to use. Personally, I use three or four moving averages on my charts.

As we said above, we should keep it simple even when it comes to moving averages, so I use round numbers for them. I use the 50 simple MA, 100 simple MA, 100 smoothed MA and 200 smoothed MA. Sometimes during strong trends and in the smaller time frame charts, I throw in the 20 exponential MA as well. They can be applied to the opening or the closing price of a candle, but it is advised that you apply them at the closing price.

The numbers for the moving averages show the number of candles used to calculate them. For example, for the 50 MA in the hourly chart, the closing price of the last 50 candles has been calculated. But you don´t have to know how to calculate them. Because all brokers offer this indicator with their platform, you just need to know how to use them for trading.

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For a review on candles: Candlestick – Forex Trading Strategies

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Defining trends

Ok, so let´s start with the important part, which is how to trade based on the moving average strategy. A moving average is a useful tool for indicating a trend. If the MA is below the price, we are in an uptrend. If it is above the price then we are in a downtrend. If the price is below and then moves above the moving average, we can consider a change in the direction of the trend. For better confirmation we should wait to see it move past a higher timeframe MA, that´s why I use more than one moving average.

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For more about Trend Trading – Forex Trading Strategies

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The USD/CHF daily chart below shows that during the first few months, the price was ranging below the 50 MA in yellow and 100 simple MA in green. It broke the 50 MA on the fourth month, which indicated that an uptrend might have begun. But as we can see it had done so a few times before, that´s why it was important to wait for a break of the 100 MA to be sure that an uptrend was being formed. About a week later it broke the 100 MA, confirming the uptrend. Later that year the price pierced the 50 MA three times during the uptrend, which showed that the trend might reverse, but it hadn´t closed below the 100 MA, therefore the trend remained intact. These are fake outs that we should be aware of and this is another reason why we should use more than one moving average. 

The break of 50 and 100 MAs confirmed the uptrend. Later we see 3 fake outs of the 50 MA, but the 100 MA has held the uptrend intact

Another safer way to spot trends using the moving average strategy (MA) is the cross over. In this strategy only two moving averages are used, usually 10 and 20 MAs. We know that the smaller MA moves faster and it is bound to cross over the other MA once a trend begins, hence the name of the strategy. In our case the green line crosses the red one. When this happens the trend is confirmed and we should enter in the same direction. This is more of a lagging strategy than the first one, which means that there´s some delay in spotting the trends. We might end up in a trade when the trend is nearly over, that´s why this strategy is usually used on long term trading. 

The trend is confirmed when the green MA crosses the red MA

Providing support and resistance

Both strategies we explained above are lagging ones and moving averages work well on them, but I’d like to use MAs as leading indicators. Moving averages are very useful tools for providing resistance and support to the price on an uptrend or downtrend. Again, it is better to use at least 2-3 moving averages for this strategy; because once one MA is breached another one comes into play. We all know that the price doesn´t go up or down in a straight line. Instead, it makes a move up, corrects for some time, then it resumes the up move again.

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For a recap on support and resistance: Support and Resistance Levels – Forex Trading Strategies

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Quite often corrections are bigger than our equity. This means that if we want to buy in an uptrend, we should wait for the correction to be over. But how do we know when the correction is done? That´s where the moving average strategy comes in handy. It works best when we add another indicator like Stochastics or RSI to this strategy. The GBP/USD chart below displays this strategy perfectly. During the uptrend on the daily chart, the price has made several corrections, retracing to the 50 or 100 MAs. It might touch the MA or get close to it; nothing works exactly to the pip in this game, that´s why we need to leave some room when placing stops. At the same time, the stochastichs have reached the oversold level. This is confirmation that the retrace is over, so that´s when we should buy. We should place the stop a reasonable level below the MA, depending on the pair and on the timeframe. 

50 and 100 MAs provide support in the daily chart

20 exponential MA provides support in the weekly chart

It would be safer if these corrections corresponded with the price touching a moving average on another timeframe chart. The weekly chart above shows the same pair during the uptrend. We see that the price touches the 20 exponential MA at the same time that the corrections seem to be over on the daily chart. Some traders use daily charts, while others use weekly ones. When they correspond it makes the resistance even stronger, because both groups buy the pair, therefore sending it higher. During strong trends, the smaller period moving averages are the ones that provide support/resistance. Then when the trends get weaker, these MAs are broken and the bigger period MAs do their job, so we should be careful when we decide to open positions after the trend has slowed. The EUR/GBP chart below shows that the 20 exponential MA has provided resistance and good sell opportunities during the strong downtrend. When the trend slowed, the 50 and 100 simple MAs, as well as the 100 smooth MA provided resistance. 

20 MA acts as resistance during the strong downtrend in the first half of the chart. The 100 simple and smoothed MAs act as resistance when the trend gets weaker

20 and 50 MAs provide resistance in the beginning, but turn into support after they´re broken

We can say the same thing for trends that begin slower but pick up the pace later. In the beginning the longer period MAs provide support, but when the trends get stronger the smaller period MAs take their place. Another thing we should know is that the MAs provide resistance, but after they´re broken, they turn into support and vice versa. We can see this in the very beginning of this chart, where the 20 and 50 MAs acted as resistance in the beginning, but turned into support after the price moved above them.v