How to Use a Moving Average Indicator?

What is a moving average?

Moving averages (MAs) are a powerful tool to confirm trends, identify trade zones and filter potential trades. Their main disadvantage is that because are a derivative of price, they are a lagging indicator, but are effective when used in the right context.

 

Types of Moving Averages:

  • Simple Moving Average (SMA): An SMA is the arithmetic mean of the data series over a selected period. With an SMA price affects the average 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 attempts to solve the lag caused by old prices by giving more weight to recent prices in the formula. 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.

 

What’s the difference?

An EMA is more responsive and smoother than an SMA which potentially results in less false signals and lag.

 

Which data to average?

  • Daily/Weekly Charts – Most people use the close of the period as it represents the final outcome, which is more important than the market gyrations throughout the session.
  • Intraday Charts – The close is less significant with intraday time periods, so we use the average prices (High – Low / 2) of each bar.

 

How many bars in the MA?

Your trading timeframe dictates how many bars are used in the series. Longer average windows (20+) smooth the MA and as a result will be less responsive to short term changes in the trend. Shorter average 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.

 

Trading Signals

  • 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 structure (support and resistance) 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 trade areas where we could enter long or short. However since the market structure clearly shows that the market is trending lower, as shown by lower lows and lower highs, we would look to focus on short positions as opposed to trying to alternate between long and short trades. We would look to enter short when the green line crosses below the red 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 to suit 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 (yellow horizontal line) 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 (the white line shows this area).

 

  • Crossovers and Value Zones- Value zones combined with market structure can be used to identify areas and the direction of trades.

 

Figure 3&4 Daily EURJPY with Crossover and Value Zones

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