Keeping Trading simple with Moving Averages
n the world of technical analysis, it is very easy to get lost in the sea of indicators out there. It starts with the free simple indicators, provided by any charting software you use and advances to very advanced, programmed, expensive indicators, sold for thousands of dollars.
Each indicator suppose to provide you some sort of edge, information, signal, or set of trading rules that help you find the right trade entry (and eventually to make money – Otherwise, nobody would have used them and they would not exist).
The technical analysis article isn’t about glorifying Moving Averages (MAs) nor it is about dismissing other indicators. I know great traders and technical analysts which use indicators like Woodies, Aroon, Ichimoku (and others..) and make really great trading decisions based on those.
he purpose of this document is to describe some of the ways people use MAs and how I set and use this very simple indicator in my overall trading strategy – The Zones.
The Basics – What is a Moving Average?
Moving Average is one of the earliest indicators used for technical analysis. It helps smooth price action by filtering price fluctuations.
Basically MA averages the closing prices for the time period it monitors (SMA 10 averages the data of 10 candles ,50 averages 50 candles and so on..)
The Moving Averages are lagging lines used to monitor the trend of an underline. They can be used as reversal signals (crossover of MA lines) or as support and resistance elements.
SMA, EMA, DEMA and others – Which one to choose?
Without getting too deep into the mathematics of MAs, the whole purpose of the different MAs is to try and find the most accurate MA setup that will provide the most reliable signals.
See this chart for example:
The blue line is the Simple Moving Average
The Red line is the Exponential Moving Average
The Green line is the Double Exponential Moving Average
If you’ll examine these lines as support and resistance lines, you’ll easily see that the DEMA (green) provides much more “buy” and “sell” signals as it is much more closer to the price. Using the DEMA allows you to identify potential reversal points much faster than if you are using the SMA for example:
The shift in trend was “picked up” by the DEMA much faster than the SMA did (20 pips sooner in this case).
By using the DEMA you get faster and more trading signals. The negative side of it is that you also get much higher frequency of false alerts:
Choosing the kind of MA isn’t the only adjustment you can do in order to find more reliable signals. You can also change the MA parameter is order to find the right balance (for you) between frequent signals and more accurate signals.
How to setup your MA?
No, I’m not going to demonstrate how to actually setup the parameters of the MA in your charting software. I guess you all know how to do it.
Setting up your MAs is basically part of and building process of your trading strategy. It has to do with your trading style (aggressive or more cautious), with your risk management (the range of your stop loss and position size) and how you want to see your trade “signal”
An example will explain it much better than words:
In this example, I’m testing 3 fast SMA (Simple Moving Average) lines. Fast SMA line for me is an SMA with a period less than 30.
I chose 3 different SMA lines to provide sell signals in a downtrend.
As you can see (it’s kind of messy, I know), the 9 SMA line (blue) provided early entry signals, but it also provided multiple false signals with huge breakouts (bigger stop loss, bigger losses).
The 18 SMA line (red), provided a little less sell signals, and less false signals.
The 25 SMA line (green) provided only 5 sell signal but all of them provided accurate entry with only small spikes trying to break the SMA resistance (allows tighter stop loss!)
Which one would you choose to add to your trading tools?
If you are a scalper, for example, seeking only 5-10 pips profit, maybe you’d prefer the faster SMA line (9), since it provides much more entries and, if the trend is quite strong, they will be pretty accurate.
If you are more conservative trader who seeks much more confirmation and assurance in your trades, the 25 may suites you well.
Sometimes, different underlines respond better to different SMA lines. When I started trading, I used the 21 SMA line after seeing that it works great with EURUSD and GBPUSD. Today I’m using a different Fast SMA and probably in the future, if I’ll see that it isn’t working for me, I’ll find another one.
*BTW, as you will see below, I’m not using SMA lines as stand along trade signals for my chart analysis.
Working with several MA lines
Just like in the previous part, Working with several MA line is another step in building and designing your trading strategy. Some people work with 2 MA lines, some with 3, some with a belt of SMA lines etc..
The principal is easy. Just like setting up one MA line, you setup additional lines that provide you more information. If you’ve set up a fast MA line, you can add a longer period that will provide you with far less trading signals but with much more accuracy level.
Having more MA lines also helps when you work with different time frames and work with cross over signals (though I find them highly inefficient, except for maybe general trend status information)
See this strategy for example:
This simple strategy uses two SMA lines when one of them is in offset. The setup creates a SMAs belt that the red line is being used to generate sell signals and the green one is used for the stop loss orders.
It is just an example of a use of MA lines. It isn’t the most accurate signal system and probably it creates a lot of false signals, but you can take a system like this, adjust it, tune it, maybe add additional rules (like, for example, the sell signal is valid only if RSI is overbought in lower time frames) and suddenly, you’ll get a system with nice results. Not everything should be highly sophisticated.
MAs in the Zone
In my strategy, I use 3 SMA line as technical elements as support and resistance elements which either helps me asses the strength of a trading zone, or being used as confirmation signals after placing the trade (see example below).
Each one of the SMA lines has different weight of how much it affects a potential Buy or Sell Zone.
By combining the different SMAs with different time frames and with the main technical strategy, which is harmonic trading and Price Action patterns, I can measure the strength of a trading zone and decide whether I want to trade it or not.
Again, I’ll use an example:
In the chart above you see an harmonic trading setup on $AUDUSD 4H chart.
As you can see the Potential reversal pattern of the harmonic trading pattern (AB=CD pattern in this case) was just above the descending 200 SMA line in a downtrend (a technical resistance element).
The combination of the harmonic trading pattern with the structure resistance zone created the sell zone I was looking for, but only once the price dropped back below the 200 SMA line, I got the confirmation signal that this trade might work – And it was a huge winner.
For me, one of the most important things is to keep technical analysis as simple as possible. I see a lot of charts out there that it takes me hours to understand what’s going on – Some of the charts of very successful analysts are just too difficult and complicated for my taste.
In this article, I gave you a glimpse of the wide world of Moving Averages. Anyone, and I do mean anyone, can find a Moving Averages setup that suits this trading style and to tune it in a way that it will provide him a simple, understandable information that will allow him to make better trading decisions.
If by writing this article, I made you think again before running to purchase your next “holy grail” indicator, I’ve done my part.
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