27 September, 2013
From time to time, I get fielded a few questions regarding moving averages, and I thought it best to write down ways to use and work a moving average in any trading situation. If anything, a moving average is the most basic tool a trader can use, as it is a clear line which shows the average price movement over a set period. E.g. a 20 day moving average would take the price movements over 20 days. However, it can also reveal key opportunities in the market, and many traders use more than one when making trades.
The most basic use of a moving average is that of a trend confirmer. Currently, when looking through the various market movements, it is easy to draw parallels between the lines when you're looking at multiple trend confirmers. Many traders like to combine multiple moving averages to be able to see trends in the markets, with people choosing different time periods to suit their strategy style. I like to use a 10 day moving average as my shortest, as it does not jump up and down, and paints a clear short term trend line. While many people have their own preference, a 10 and 20 day moving average is the most common.
For example, if we had say two moving averages on our screen and one was a 10 day moving average while the other was a 30, we would expect the 10 day to always be above the 30 day moving average if we had a bullish (rising) trend. If we had a bearish (falling) trend, we would once again expect that the faster moving average would be below the slow moving one. A crossing of these two can actually point to a change of trend. So traders look to combine this with other tools to see when a trend may be coming to an end.
Traders can also look to cross trade with a moving average. When looking for trends in the marketplace, using moving averages can point to some easy trading opportunities, despite it being a lagging indicator.
From the example above, we can see that when we have a crossing of different moving averages, it can lead to great trading opportunities. The red represents a 15 MA, while the blue at 30 MA. We can see that generally when the 15 MA pushes through the 30 MA, a trend forms. This is a signal for traders to take advantage of the situation. If you had purchased as the red 15 MA broke through the blue 30 MA, you would have made some advantageous trades until the 15 MA retreated back through the 30 MA.
Dynamic Support and Resistance
Additionally, when looking at moving averages, they can act as dynamic support and resistance levels. What this means is that instead of the traditional support and resistance levels that we see, markets will instead use the moving average as a form of support and resistance when looking for points to bounce off. This can be seen throughout the above example as the market looks to use the much slower moving average as a point of resistance through the month of September.
We have seen that moving averages play an integral part in any traders toolbox, and with a little deeper understanding, they can be used in a variety of different aspects such as the trend confirmer, breakout confirmer and dynamic support and resistance. If you are using only a few of the basics when trading, this would certainly be a key one to help you.
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