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Moving Average (SMA/EMA) - How to trade trends

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Lesson 2

Available in different formats, the moving average (MA) is a simple continuous line plotted on the price chart. The moving average, as the name suggests, plots the average price over a fixed period of time.

Traders can use the double crossover strategy based on two moving averages to identify potential price reversals.

The MA indicator is one of the simplest, yet most powerful, technical indicators available today. Based on where the price is situated compared to the moving average, traders can identify the trends in the markets. Moving averages, as a technical indicator, have been used for decades. Despite being very old, this technical indicator has stood the test of time.

Many professional technical traders continue to depend on the moving average indicator as it is widely used in almost all financial markets. This includes stocks and futures other than forex.

Moving averages indicators

Moving averages can be broadly classified into several types. The main difference between these types of moving averages is how the calculation is performed. Most moving averages are based on a math formula that calculates daily close price.

The main types of moving averages are as follows:

  • Simple moving average
  • Exponential moving average
  • Linear weighted moving average
  • Smoothed moving average

In addition to these main types of moving averages, there are other custom moving average indicators, such as the Arnaud Leroux. Despite the different types of MAs available, the SMA and the EMA are the most widely used technical indicators when it comes to following trends.

Simple MA vs. Exponential MA

The simple moving average, or SMA, is based on calculating the average price over a fixed period of time. This is also referred to as the look back period of the moving average. Some of the most common simple moving average settings are the 50-day SMA and the 200-day SMA. Shorter versions include the 10- and 20-day moving average as well.

One of the main drawbacks with the simple moving average is that it remains constant. Thus, any immediate price increases or decreases take time to be reflected.

To make the moving average more sensitive to the recent prices, the exponential moving average is used. The EMA has the same calculation as that of the simple moving average. However, more weightage is given to the recent price. This ensures the EMA is more reactive to the latest change in prices.

The moving average indicators are based on the closing price. However, traders can use their own variations and use the high, low, close, open or mid-price and build the moving average accordingly.

How to identify trends with MA

Trend identification is an important concept when using the moving average indicators. Price of a security is said to be in an uptrend when it makes higher highs and higher lows. At the same time, price tends to be above the moving average.

Similarly, a downtrend occurs when the price of a security makes lower highs and lower lows. Price also trades below the moving average, signalling the trend is down.

Based on the trends, traders can look for appropriate positions in the markets. One can place a Call or Put binary option when there is a bullish or bearish crossover of the moving averages.

The trends can also change depending on the time frame being used. For example, you may find the price action is in an uptrend on an hourly chart, but the 5-min chart shows price is in a downtrend.

This is because price seldom moves in a straight direction. It often makes a pull back and moves in a zig-zag fashion. Thus, traders should always ascertain the main trend and then trade in the direction of the main trend on lower time frames.

Traders are able to better pick their positions in the market and trade in the majority. Of course, counter trend trading can also be done when the price is moving in an opposite trend in the lower time frame.

MA crossover strategy

Using two moving averages is also referred to as the double crossover strategy. Notably, quite often after a bullish or a bearish moving average crossover, price tends to pull back before resuming the trend. Therefore, sometimes, it is better to wait for the pullback instead of simply going for a Call or Put trade.

The moving average crossovers are based on using one short-term moving average and the long-term moving average. The double crossover strategy is based on the following concept: when the short-term average price is higher than the long-term, the trend is said to be bullish.

Bullish crossover

A bullish crossover with the short-term over the long-term MA is also known as the golden cross. This can be applicable to the 10-period and the 20-period moving average.

MA bullish crossover

Bearish crossover

Conversely, when the short-term average price is below the long-term average price, the trend is said to be bearish. A bearish crossover is also referred to as the death cross. This happens when the 10-period moving average crosses below the 20-period moving average.

MA bearish crossover

Depending on the time frame in question, traders can set their own fixed values. Typically, in the short-term, traders can set the moving average values of 5 and 10 or 10 and 20 and so on. Some traders also prefer to use the Fibonacci numbers for the moving average settings.

Moving averages are simple yet powerful technical indicators that can guide traders to trade better in the direction of the trend. The MA is one of the most widely used technical indicators, and many traders prefer to use at least one moving average in their trading strategies.

Comments

Brial's picture

hello guys. I watched a video from this web on youtube with a strategy of using BB bands and the moving average. Were put trades are placed when the moving average is moving down and there happens to be a break of the upper band. Sort of. What i am missing is the moving average type and the setting. Kindly help

Brial