Moving Average 101 – An Important Tool in Every Trader’s Toolkit


Introduction

Moving averages are one of the most commonly used technical indicators in the industry.

Many traders watch how price reacts around these averages to qualify trades.

When used in the right context, they can be a very powerful tool in your arsenal.

In today’s article, we will distinguish the common types of moving averages, popular period settings. As well as some tips on how to use them effectively in your trading.

What is a Moving Average?

A Moving Average (MA)  is a study that plots the average price over a specific period on your chart.

It is a mathematical formula which is calculated by averaging a number of historical data points.

Since this data is smoothed over, it helps traders from getting caught in the noise of daily price fluctuations.

There are several variants of the moving average, however, we will focus on the two most common: Simple Moving Average and Exponential Moving Average.

What is the Difference between the SMA & EMA?

In one word: Responsiveness

The exponential moving average is more responsive to price than the simple moving average. This is because the calculation of the EMA places more emphasis on recent data points. As a result, EMA will generally have a higher value than the SMA when a market is rising and will fall faster than SMA when a market is dropping.

The below example gives a visual representation of the difference in responsiveness between the two moving averages (EMA is red / SMA is yellow)

NZDCAD MOVING AVERAGES EXAMPLE

NZDCAD MOVING AVERAGES EXAMPLE

Which is Best for You?

Well, that depends on your style!

If you are a more aggressive trader, the EMA may suit you better than the SMA. This is because it reacts to price faster and can indicate potential shifts in direction sooner than the SMA. While providing earlier and more frequent signals than the SMA, the main drawback is that you are more prone to false signals.

A conservative trader would prefer the SMA as it reacts slower to price than the EMA. It can keep you in the trend longer, however, you will also get into trades later than the EMA resulting in less potential profit.

At the end of the day, it comes down to personal preference. The best way to determine which is better for you is to plot both on your charts and study them. Whichever complements your style the best is the one you should keep!

What Setting Should I Use?

The most common period settings used by traders are the 10, 20, 50, 100 & 200 moving averages.

Other traders in the world focus on these levels and use them as a means to commit capital when acting on their trade signals.

The 10-period moving average (ORANGE) best suits day traders. This is the most responsive of the bunch and reacts to price changes immediately

The 20-period moving average (YELLOW) best suits short-term swing traders. It is a good gauge of short-term market sentiment and acts as dynamic support and resistance in trending conditions.

The 50-period moving average (RED) is a staple for swing traders as a gauge of medium-term market sentiment. It is also effective as dynamic support and resistance in trending conditions.

The 100 & 200-period moving averages (AQUA BLUE/PINK) are best suited for position traders. They are a great gauge of long-term market sentiment.

AUDCAD Moving Averages Example

AUDCAD Moving Averages Example

How To Use Moving Averages Correctly?

Moving Averages serve two main purposes in our analysis :

(1) Trend Filter

Trading with the trend is one of the better ways to put probabilities in your favor.

We like to lean on moving averages to determine current order flow. Not only do they help us identify underlying trends, but they also help us spot potential sentiment shifts quite early.

Case Study

The below chart of the USDCAD pair serves as an example of how to effectively use the MA as a trend filter.

While this market is trading above the MA, order flow is considered bullish. As long as the market stays above the MA, only LONG trades should be favored.

A break of the MA in the context of a trend, as seen below, can signal a potential reversal is starting to take place. When we see this, it is a sign the prevailing trend may be exhausted and needs a breather (see both aqua circles on chart). This can result in one of two scenarios. (1) A consolidation before another move in the direction of the overall trend. (2) A complete reversal of the overall trend.

In the below example, we see the latter. After several weeks of trending higher, the market finally closes back below the MA. The market rotates into the MA and fails. Once we see the continuation lower, the reversal is in full motion.  At this point, order flow is bearish and the sellers are in control of this market. Only SHORT positions should be considered until the market closes back above the moving average.

USDCAD Moving Averages Example

USDCAD Moving Averages Example

(2) Dynamic Support & Resistance

In our experience, moving averages tend to act as great dynamic support and resistance in trending markets.

As you should know, the market does not move in a straight line. It will often oscillate in cycles of buying and selling.

During trending periods, the market offers low-risk opportunities in the form of pullbacks. These pullbacks are the result of profit taking, as well as counter-trend traders entering the market.

Moving Averages are popular counter-trend fade targets during these pullbacks and help us identify areas of value within the trend. These are levels that offer low-risk entries to jump in on the train before it leaves the station.

It is important to note that MA’s are only effective as dynamic support and resistance in the context of trending markets. If a market starts to consolidate and build a range, MA’s tend to lose relevance for us until we see a new trend begin to emerge. Only once a trend begins can we start to consider MA’s as tradeable levels of dynamic support and resistance.

 

USDCAD Moving Averages Example

USDCAD Moving Averages Example

Case Study

In the above example, the 20-period moving average (YELLOW) is plotted alongside the 10-period moving average (ORANGE) on the USDCAD Daily chart.

A good trick we like to use is to plot two different moving averages on your charts and use the area between them to identify levels of value within trends for trade setups. Pullbacks into these levels offer high-probability trades to join the trend.

Notice that as the market trades higher, both MA’s are pointed upward and are noticeably separated. This indicates that order flow is currently bullish. With a trend in place, the area between the moving averages is now considered a level of value for buyers. These moving averages should now hold as dynamic support if the market trades back into them.

Alternatively, as the market trades lower, the MA’s are pointed downward and are noticeably separated. In this scenario, order flow is bearish and the moving averages should now act as dynamic overhead resistance. As the market trades lower, you can see how well the moving averages acted as resistance.

The trend is firmly bearish until the market closes back above the moving averages in May. This is the first indication that the sellers may be losing steam and we might see a breather. After this breakout, the market enters a long period of consolidation, until eventually forming a new bull trend.

If you pay your attention to the highlighted range above, you’ll notice that price does not respect the moving averages as support or resistance in sideways markets. Trading through this chop can blow you up real quick! This is why it is so important for a new trend to emerge before considering this tool as dynamic support or resistance.

Final Thoughts

While there is no holy grail indicator in this business, the moving average is certainly a very useful tool for any technical trader.

We hope you’ve walked away with the knowledge required to implement moving averages to your arsenal.

If you want to learn more about moving averages, check out our Youtube video on the topic here

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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.