Looking at Different Ways to Use a Moving Average in Your Trading – Part 1
Everyone interested in trading has probably used or at least tried a Moving Average at some point in their trading career. But most only apply the Moving Average (MA) in the conventional sense, as a trend trading tool. However the MA can be used in other ways too and we'll look at the different ways to use a moving average in this article.
The moving average, just like the name implies, averages the price of the past X periods, a 20 period MA represents the average price of the past 20 periods. The average can be applied to the close of the bar (or period) which is the most common use of it, but it can also be applied to the open, the high or the low of the bar.
There are different types of moving averages, the Simple Moving Average (SMA) is calculated by adding up the closing (or open/high/low) prices for the previous X periods and dividing the sum by X. The Exponential Moving Average (EMA) and Weighted Moving Average (WMA) give more weight to the latest data, so they will be more responsive to recent price moves then a SMA.
The most popular moving averages are the Simple 50, 100 and 200 Moving Averages applied to the close price. Allegedly these MA's are used for technical analysis by the big banks. The 10 and 20 SMA are also quite popular.
Use Number 1 – Using Moving Average Crossovers as a Trend Trading Tool
The most common use for a moving average is as trend trading tool, where several MAs are plotted on a chart. Below you can see an example of this with the 50, 100 and 200 SMAs.
A buy signal is generated when a faster or shorter MA crosses above the slower or longer MA. Reverse that for a sell signal. Two or more MAs can be used for the crossover. In the example above all 3 MAs are used to generate a crossover signal. A buy signal is generated on August 17 when the 100 SMA crosses over the 200 SMA, the 50 SMA was already trading above both slower MAs at that point. The EUR/USD rallied 461 pips from that point until now.
But to get the complete picture, we have to look at a market situation where the SMA crossovers and MAs in general perform poorly. Below you can see an example of a ranging environment, the moving averages keep generating crossover signals and whipsawing up and down. The likely result for the chart above would be 4 losses in a row.
Use Number 2 – Using Moving Averages to Identify Ranges
The chart above also showcases another use for the moving average, as a tool to identify ranging periods. A flat moving average is a good indication that price is consolidating. When using several MAs like in our example above, you can also spot a range when the MAs start to clump up together. However unlike the crossover signal which is mechanical, this usage for the MA requires a lot more screen time and experience to use effectively. We'll go over more ways to use the moving average in my next article, in the meantime experiment with the 50, 100 and 200 SMA and see if you can spot new uses for them yourself.