by simon on March 23, 2013
That is a common problem among investors. They are looking for best working moving averages. But do you know there are few ways you can use moving average in your trading plan?
Do moving averages crossovers really works?
Take ten new traders and tell them to create trading system and I am sure that more than 70% of them will use moving average crossovers as a part of their system. It is not a suprise. Moving averages are one of the oldest technical indicators. They are in use since 20’s of XX century so almost 100 years. Of course over time people find more sophisticated ways of using them. Also we have many more types of averages, but the concepts behind creating them are still similar.
But do they work?
From the beginning of using ma’s traders were trying to find profitable crossover signals. You may be familiar with concept such as Golden Cross and Death Cross. But there is no one simple answer to the question. When there is a strong trend then signals from moving average crossovers work pretty great:
When there is no clear direction – the market is moving sideways or what’s worse is very choppy, then quality of buy and sell signals from moving averages is very low:
So it depends more from the way you are going to use averages – does your trading plan takes such a scenario into an account?
But wait, there are another ways of using moving averages
I started from crossovers topic because many new traders think that this is the main way of using them. They are wrong. Below you can find few examples how you can use averages in different ways.
Moving average as a trend detector
You simply take longer time frame and observe where the price is. So in the example below we are looking at 200 moving average. When price is above that average then that is a signal for us that the overall trend is up:
When price is sitting back below average for most of the time, than it’s sign that sellers are stronger at the moment:
What is the direction of average?
You should also pay attention at what direction moving average is pointing. If it’s pointing up, then the there are better chances that trend up will continue.
When it’s pointing down then it is possible, that there is a correction taking a place or down trend will continue to expand.
Is price crossing through moving average?
This is also a valid signal. When price for most of the time was right below average and suddenly is corssing through to the other side than it is a sign that overall sentiment may be changing like in the example below:
Moving average as a support or resistance
That is a very important function. Some averages are commonly used by traders, for example 50, 100 or 200 averages. They are very popular and when price is moving near them then you can expect some kind of reaction. If price was most of the time above average, it is possible that there will be support. Check the example below:
On the other hand, if the price is below averages and is moving closer to them, then it is possible that averages will work as a resistance area.
As you already know, knowledge about possible support and resistance areas is very worthy. You can write this into your trading plan and close trades at better moments.
How many averages should you use?
It depends strongly from trader and trading style. For beginners I suggest to put on chart at least one average from each group. We can divide averages in three main groups:
- Short-term group – averages from around 1 to 20. They are helpful when you want to check the current short-term trend.
- Medium term group – with averages from around 20 to 50.
- Long term group – averages from period from 50 up. With long term averages you are able to see better the bigger picture.
Periods may be different for some traders. The values from above are there to give you some idea about scope of each group. So you just want to have one average from short-term group, one from medium and one from long term group. You may create set like:
- 10, 50, 200
- 5, 33, 100
- 7, 21, 200
- any other combination
I think that the good start is to use 13, 50 and 200 moving average.
Test it and see which one is the best for your trading plan.
Other tools based on averages
You can also use moving averages and create MMA – Multiple Moving Averages. Popular exapmles are GMMA and Rainbow Chart. These charts are good to invest with the main trend but this is topic for another article. For now I wanted to mention that there is such a thing as MMA.
There is a much more to learn about averages, but the most important thing is to practice.