*Looking at the use of moving averages and exponential moving averages in my trading strategies*
It’s Tuesday the markets are open and we have started a new week. Before I start this blog post, I think it’s always wise to remind yourself that whatever happened in your trading last week is done. Whether it was good or bad, just take note of it and forget about it until you do your trade reviews. Don’t let it affect this weeks trading.
Now, let’s talk about a trading indicator that you may or may not have heard about before. It is commonly used by may traders and investors in one form or another and is often incorporated in to algorithmic trading strategies because of its effectiveness.
I am talking about the moving average.
Moving Averages – What is a moving average?
A moving average (MA) is the calculated average of a give data set. This is the standard definition but more specifically to trading, it is the calculated average of price over a given time period plotted as a line on your chart. It is considered to be a technical indicator that is widely used across investing and trading industries. They are normally calculated using the close price of a specified time period but this can be changed along with the length of time used to calculate the average.
Moving Average Formula = (P1 + P2 +P3 + Pn) /n where n represents the number of periods you are using for your MA.
Popular Moving Averages.
The most popular moving averages used are probably the 200 and 50 MA’s which calculate the average price of the last 200 and 50 time periods in question. Now this may sound complicated but essentially, the 200 MA will be different depending on whether you are using the 1 hour, daily or weekly timeframe charts. This is because the moving average calculator will use the last 200 hour candle close prices for the 1hr 200 MA and it will use the last 200 weekly candle close prices for the weekly 20 MA.
The weekly 200 MA will be different to the weekly 50 MA because it creates and average using the close prices of the last 200 weekly sessions where as the 50 MA will use only the the close prices of the last 50 weekly sessions.
The chart below shows the 50 & 20 moving averages on the weekly chart for the FTSE 100 Index.
As you can see on the chart above, the different MA’s react with price differently. The 50 MA follows the movements of price much more closely and produces more interactions with price vs the 200 MA which is a longer term indicator. This is because it uses a larger time period to produce the average.
There are also multiple variations of the moving average that traders investors can use to help them when trading. The other most commonly used one is the Exponential Moving Average which is similar to the standard MA but weighting of each price period is decreased exponentially. This is to reflect the relevance of recent price periods over older price periods.
You can also get Smoothed Moving Average, Hull Moving Averages and Weighted Moving Averages.
Exponential Moving Averages (EMA’s).
The exponential moving average (EMA) is my personal favourite. I prefer it to the standard moving average because of how it tracks with price and interacts with it across the multiple timeframes that I trade. Before I continue, this is my own personal opinion that I have established through my years of trading but you might not agree. It is up to you as to whether you incorporate moving averages in to your trading strategies.
The chart below is the same FTSE 100 weekly chart as above but it has the 50 and 200 EMA applied to it.
You will notice that the 50 EMA has shifted slightly in respect of where the 50 MA was sat and reacted with price. The 200 EMA has also moved vs the 200 MA and this is because of the exponential weighting of more recent price periods in the exponential moving average calculations.
Later on in this blog post I will show you examples of how I use the 50 EMA and why.
Benefits & Uses of Moving Averages.
The main use for moving averages is to spot the prevailing trend in a market on the current timeframe. If price is residing above an MA then it is considered to be in a bullish trend. If price is residing below the MA then it is bearish.
Another use for moving averages is to use more than one MA each with a different period and use their alignment to predict the current market trend also predict where trends reverse.
MA / EMA alignment is a tool I use in my day trading strategy to make sure I am trading alongside the near term trend. If the short term MA is above the longer term MA then it can be used as an extra confirmation that the trend is bullish. If the short term MA is below the longer term MA then it can be used to indicate a bearish trend.
The chart above shows a bullish moving average alignment on the FTSE 100 Index. The short term MA (20) is above the longer term MA (50) indicating a bullish trend and as you can see, price slowly continues to creep upwards with it retesting and rejecting the moving averages that are acting as support.
The MA crossover is a trend reversal “signal” that is (or was) commonly used in investing and trading. When the short term MA crosses above the longer term MA then this indicates the current trend is turning bullish. It is the opposite if the short term MA crosses below the long term MA.
As you can see on the chart above, the 20 MA crossing below the 50 MA on the weekly timeframe then lead to the FTSE 100 Index trend reversing and the market crash of 2008 occurring. Obviously, the MA crossover didn’t actually cause the crash but it acted as a nice indicator of what was to come.
Top Tip: Practice and perfect your strategy by trying multiple MA’s and EMA’s and find what works for you. The MA periods I use in tis blog post are for example purposes only.
Limitations of using Moving Averages in trading.
The main limitation with using moving averages in your trading is when the markets consolidate and become range bound. You will then start to see more frequent price interactions with your MA’s/EMA’s and this can lead to a greater quantity of less quality trade signals. This is why it is important to use multiple confluences in your analysis when trading.
Ranging markets can cause the most problems for MA crossover trading strategies because as markets consolidate, squeeze and range sideways, you can often see multiple MA crossovers in both directions. This will produce lots of fake trade signals.
Another limitation, or definitely something to bear in mind, is that MA’s will move as you switch timeframes and that is why it is very important to do multiple timeframe analysis. You will notice on all my previous blog posts that I continue to emphasise the importance of looking at all timeframes when analysing the markets.
Price may be residing below the 50 EMA on the 1hr timeframe but it could be above the 50 EMA on the 4hr and daily timeframes. It is important to check that they all align in order to achieve the best success rate with trades.
How do I use Moving Averages?
So now is the bit you have all been waiting for… how I use moving averages in my trading strategies.
Firstly, I don’t actually use moving averages. I only use exponential moving averages (EMA’s) and I stick to just using the 50 EMA and 200 EMA.
The main purpose for a moving average in my trading is when I am trading my trend reversal strategy. I incorporate the 50 EMA in to my strategy as an extra confluence to confirm the potential reversal is definitely occurring and I then use it for my trade position entry.
The chart below shows the 1 hour chart for the NZDJPY FX currency pair. I have the 50 EMA applied and as you can see, it often continues to act as a dynamic resistance for price over a good period of time. Used with a good risk management strategy and other analysis, it can be a very effective trading tool.
Another use I have for EMA’s is for confirming the current trend on a given timeframe. I use the alignment of the 50 EMA and the 200 EMA in my day trading strategy to confirm the current trend in order to make sure any positions I may take in that day are on side with the overall trend. Over a long period of time I have found this to help with the success rate of my day trades.
The chart below shows how the alignment of the 50 & 200 EMA coincides with the bearish trend for the 4 consecutive trading days. The shorter term EMA being below the longer term EMA indicating a bearish directional bias.
So there we have it, this is my basic guide to moving averages, what they mean and how one can use them in trading and investing. This is not a definitive guide tot he uses, benefits and limitations of moving averages, this topic could easily fill a 100 page book.
As always, do your own investigating and experimenting with moving averages before you use them in your trading strategies. I personally believe they are a great tool to use alongside other analysis.
DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.