How to Use a Moving Average Indicator?
Moving averages (MA) are a powerful tool to confirm trends, identify trade zones and filter potential trades. Given that MA’s are a derivative of price their main disadvantage is they are a lagging indicator but are effective when used in the right context.
Types of Moving Averages:
- Simple Moving Average (SMA): A SMA is the arithmetic mean of the data series over a selected period. The issue with SMA’s are price affects the SMA twice (when it first enters the series and when it drops out) meaning that a spike in price may push the SMA higher initially and then when that data point drops out of the series the SMA may decrease significantly leading to false signals.
- Exponential Moving Average (EMA): An EMA caters for lag by giving more weight to recent prices. The major benefit is that data points are squeezed out of a series as opposed to being dropped off at the end of the series.
Which MA is best?
EMA is more responsive and smoother than an SMA resulting in less false signals and lag.
Data to average?
- Daily/Weekly Charts- Use the close as it represents the outcome from the trading period, which is more important for this timeframe than the market gyrations throughout the session.
- S/T Charts- The close is less significant therefore, use average prices of each bar.
How many bars in the MA?
Depending on your trading timeframe and how you want to use a MA will dictate how many bars in the series. Longer windows (20+) smooth the MA and as a result will be less responsive to changes in the trend. Shorter windows (10-20) will be more responsive to changes in trend but are more likely to be effected by noise, which can lead to false signals and the trader being whipsawed.
- Crossovers- MA crossovers help traders identify the current direction in a market. When the shorter period MA crosses above the longer period MA this signals that there is potentially a bullish trend developing. On the other hand, when the shorter period MA crosses below the longer period MA this signals that there is potentially a bearish trend developing. In sideways markets there may be false signals. To counter this issue use both market structures and MA crossovers to determine trend direction.
Figure 1 Daily EURJPY with short crossover signals
Using an 11-day EMA (Green) and a 22-day EMA (Red) crossover in figure 1 identifies potential trades where we could enter long or short. However the market structures clearly shows that the market is trending lower shown by lower lows and lower highs throughout the whole move. Using the crossover with market structure allows us to focus on short positions as opposed to trying to alternate between long and short trades. We would look to enter short when the red line crosses on top of the green line.
- Value Zones- A value zone is the area between two EMA’s. This zone is a good area to look to enter trend continuation trades. In figure 2 we use a 50-day EMA and a 100-day EMA however, these periods can be adjusted for each market. Value zones also identify the underlying longer-term trend. When the shorter EMA is above the longer EMA there is a bullish trend (Green) and when the longer EMA is above the shorter EMA the trend is bearish (Red).
Figure 2 Daily EURJPY with 50/100-day value zones
The market structure here is bullish as we have seen a significant resistance level broken and a strong move higher. Following a large move like this it is common to see a complex pullback which is a continuation pattern. The complex pullback and double bottom into the value zone provide an opportunity to enter long.
- Crossovers and Value Zones- Value zones combined with market structure can be used to identify areas and the direction of trades. Crossovers can then be used to execute the trade.
Figure 3&4 Daily EURJPY with Crossover and Value Zones