Moving Averages

Prices can only move in three directions; up, down and sideways. The direction determines the trend. The purpose of all tools used by technical traders is in fact to identify and evaluate trends and to indicate potential changes in these trends.

Prices do not move in straight lines, but go in a series of peaks and troughs. These peaks and troughs can be used by short term traders whilst loner term traders simply prefer to smooth out some of the markets, which basically gets rid of any unnecessary noise, this then makes the underlying trend easier to see. The technical indicator to show this are moving averages.

Moving Average
Moving Average Confirms Trend

Using moving averages when trading only really work in a trending market. If you apply them to a sideways market, the market will chop above and below the average and not stick to the rules.

Types of Moving Average

There are three common types of moving averages, all of which are calculated differently:

  • Simple Moving Average (SMA) – The same weight is given to each price and only the prices in the period covered are taken into account.
  • Weighted Moving Averages (WMA) – More weight is given to the more recent prices and only the prices in the period covered are taken into account.
  • Exponential Moving Average (EMA) – All previous prices are taken into account and give a similar result to the SMA. This is the most widely used moving average.

Fast Vs Slow Moving Averages (MA)

How sensitive you have your moving averages is up to you. The more sensitive or faster your MA is, the earlier you will get signals, which is great as you’ll get into the market early however it also gives a lot of false signals. You may fall a victim of ‘whipsawing’.

The less sensitive or slower an MA is, the later the signals are. These signals can be for a trader to get into and out of a trade, a delayed signal could cost the trader considerable profits. Therefore, the best MA should give you early enough signals but avoid you getting whipsawed. Easier said than done!

Fast Vs Slow Moving Average
Fast Vs Slow Moving Average
Fast Moving AveragesSlow Moving Averages
Tick Trading signals are given early in the moveTick Give a better view of the general direction
Tick Signals may be given against the trendTick Suitable for use in long trending markets
Tick Some false signals may be generated by market noiseTick Don't get caught in small corrections in long trends
Tick Track the trend from a greater distance, hence giving later trading signals
Tick Unsuitable in trendless markets, as the price whipsaws around the line

Moving Average Trading Systems

Buy and sell signals are generated when the price moves above or below the moving average.

To try to avoid false signals, traders like to look for confirmation that the signal is correct. Confirmation can be various things, including secondary indicator confirmation, candlestick analysis or a trend line break. You can also use filters the same way you would during a break of a trend line or support and resistance.

Confirmation

  • The moving average and price line must have the same direction.
  • The entire day’s price range must confirm the signal.
  • The signal must be confirmed by a different signal.

Filters

Price filters

The price must penetrate the moving average by a certain predetermined percentage of the current price or by an absolute price value (set by the user).

Percentage Envelopes

Parallel lines are drawn at a certain percentage above and below the moving average. Then, to generate a sell signal, the price has to close not only below the moving average but also below the lower envelope line (and vice versa for buy signals above the upper envelope).

Then a close above the moving average itself (or below the moving average for long positions) leads to liquidation of the position. A buffer ‘neutral zone’ is created between each of the percentage envelopes and the moving average, within which no action is taken.

High-Low Band

Identical moving averages are applied to the highs and the lows of each day. A buy signal is generated when the price crosses above the higher line and then the lower line is used to generate the stop out point. Conversely, a sell signal is generated when the price crosses below the lower line, and the upper line then becomes the stop out point.

The same comments can be made on the filter’s choice as on the choice of the moving average’s duration. If the filter is not effective enough, it is not much use in reducing the false signals, but if it is too effective, then an important part of a price movement will be missed before a signal is triggered. The dealer has to determine which filter is the most appropriate to their market, risk appetite and trading timescale.

Time Filters

The user delays for ‘n’ (usually 2 or 3) days before taking any action (i.e. The signal must remain in force for more than one day). In this way, a lot of false signals are avoided, but there is the inevitable disadvantage of later entry into good trades.

Conclusion

Sometimes a short moving average will work better than a longer moving average and vice versa. Thus, the use of one moving average may not always give the best results, necessitating the use of filters. Therefore, to improve the reliability of this method, most technical traders prefer to use two or three moving average systems.


Two Moving Averages

When using two moving averages, the longer average is used for trend identification and the shorter average as a timing technique. Different rules may be used:

Technique 1:

A buy signal is given when the short moving average crosses upwards through the longer one, and a sell signal is given when the short moving average crosses downwards through the longer one.

Two Moving Averages
Two Moving Averages

For example – if a 10-day and a 50-day EMA combination is used, a buy signal is given when the 10-day average moves above the 50-day average, and vice versa for a sell signal. In this approach, the system is continuous, meaning that it is in the market (long or short) all the time. It eliminates many of the false signals during sideways markets that would be given by using just one moving average, but it is slightly more lagging (i.e. trading signals are given later).

Technique 2:

A buy signal occurs when the price moves above both moving averages and a close out signal is given when the price moves below either moving average (vice versa for a sell signal). In this approach, the system is not always in the market. A neutral zone is created where no position is taken or kept.

Some traders also wait for a confirmation, i.e. buy signals are only acted upon when the shorter moving average crosses above the longer moving average AND when the latter is itself increasing; sell signals are given when the shorter moving average crosses below the longer one AND when the latter is itself decreasing.

Three Moving Averages

For the three moving average systems, different techniques may be used to calculate the signals. As for the two moving average systems, we can classify these systems into two categories with respect to their presence in the market. Continuous systems and non-continuous systems.

Continuous Systems

A buy signal occurs when the shorter moving average crosses above the longer one, and a sell signal occurs when the shorter one crosses below the longer.

Non-Continuous Systems

A neutral zone is created when the shortest moving average crosses one of the other two. The trigger signal is the crossing of the shortest with the third one.

Triple Cross-Over Method

As stated before, the shorter the moving average, the closer it follows the trend. For a three moving average system, M1, M2 and M3 (with M1 being the shortest and M3 the longest), in an uptrend, the proper alignment should be M1 above M2 above M3 (M1>M2>M3), while in a downtrend, the respective values should be M1<M2<M3.

A buy signal is given at the moment the situation M1>M2>M3 occurs and a sell signal is given at the moment the situation M1<M2<M3 occurs.

  • When the uptrend reverses, the first thing that should happen is that the shortest one (M1) crosses below the other two – this is a selling alert.
  • When M2 crosses below M3, the selling signal is triggered.

However, these rules can be adapted by the user, and in fact some dealers use the first crossing to start liquidating their long positions, since lagging remains a significant issue when using these moving average cross-over methods.

Three Moving Average
Three Moving Average

Moving averages are plotted on the actual price chart, technicians also use moving averages that are plotted as oscillators below the chart.

 

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