Moving averages are a classic technical analysis tool that may be misused at times. There is a right way to use moving averages in technical analysis and one can use them to day trade options as well. The key is to understand which moving averages are useful in day trading and how to use them accordingly. This is not a moving average crossover strategy, there are a lot of those online that you can find easily. This is an actual moving average strategy that works.
The article is going to break down the following:
- What are moving averages
- Moving averages & time charts
- Which moving averages are best for day traders
- Day trading options with moving averages
1. What Are Moving Averages?
The easiest way to describe a moving average is; it is a technical analysis indicator that is calculated based on the closing average price of the underlying asset. This way it is constantly updated, to give us a smooth average of the underlying price. Which allows traders to identify if the stock is doing well (above its average) or doing poorly (below its average).
There are many different moving averages, simple moving averages that take into account the arithmetic mean (average) of prices set over a specific number of days. For example, 20, 34, 50, 100, 200 days etc.
There is also the exponential moving average, which is a weighted average of the underlying price that gives more weight of importance to the most recent days. Making the indicator way more responsive to new information. You can make a moving average any length you want as a whole number.
Take a look at the example below, where we have A LOT of moving averages, now we don’t use all of these for trade, especially day trading. We have these all on a chart to emphasize the different variety of the averages. The main things I want to focus on are the thick yellow average and thick pink average.
The yellow: 200 Day Moving Average
The pink: 200 Day Exponential Moving Average.
You’ll see there is a more exaggerated difference at the end between the two.
2. Moving Averages & Time Charts
There are different moving averages as we mentioned before, but there are certain averages that are reflected better on specific time charts. Meaning that you cannot expect the 200day average to show the same values on a daily chart as well as on a 1-hour chart. Whatever the average is on the daily, will be different from whichever other time frame you explore.
You can change the settings for the moving averages so that they do reflect the daily, no matter which time frame you go on. However, it is not advantageous.
Let us break down the charts and which averages correspond best to each chart.
- Daily: 200 MA, 200 EMA, 50 EMA, 34 EMA, 20 EMA
- Hourly: 34 EMA, 50 EMA, 20 EMA
- 10-min: 34 EMA, 50 EMA, 20 EMA, 12 EMA, 5 EMA
- 5-min: 20 EMA, 12 EMA, 5 EMA
Below is an image of all of the moving averages that we talked about above.
- Top left: Daily
- Top right: hourly
- Bottom left: 10-min
- Bottom right: 5-min
3. Which Moving Averages Are Best for Day Traders
The question persists, we have all of these pretty averages, but what do day traders use? Which moving averages and which charts?
Day trading involves the use of many charts, in something that is called multiple time-frame analysis. Where we start from a large timeframe and start dropping down to smaller time frames. For example, start on the daily and hourly to get the main levels, then actually trade on the 5-min chart.
Meaning, I will do my analysis on ALL 4 of the charts presented above. However, in terms of moving averages, I will focus mainly on the ones present in the 10-min chart and the 5-min chart as a day trader.
Meaning, we will use:
10-min chart and levels, along with the 34, 50, 20, 5, 12 EMA to guide us in the general direction of the trend.
- The 10-min chart allows us as traders to use a moving average cloud that combines the moving averages (a shorter and a longer) to create a ribbon as an average guide.
- On the 10-min chart, we focus on the 34/50 EMA area and look to it as a guide. If we are above and green, then the sentiment is for a bullish trend. Below and red, the sentiment is for a bearish trend.
- The 20 EMA on the 10-min allows us to identify a similar trend, as long as we can hold the 20 EMA as the pullback area and respect it the trend will continue.
- The final averages that are used in the 10-min are the 5/12 EMA cloud or ribbon. In a trending market these averages are ideal for pullbacks and continuations. As long as these areas are held, you can use them as a trailing guide.
Take a look at the example below, the averages are as follows:
- 34/50 EMA (purple/blue. Purple is bearish, blue is bullish)
- 20 EMA (solid blue line)
- 5/12 EMA (red/green. Red is bearish, green is bullish).
We would also use:
- 5-min chart and levels, along with the 20, 5, 12 EMA to guide us in the general direction of the trend.
- The 5-min chart allows us as traders to use a moving average cloud that combines the moving averages (a shorter and a longer) to create a ribbon as an average guide.
- The 20 EMA on the 5-min allows us to identify a similar trend, as long as we can hold the 20 EMA as the pullback area and respect it the trend will continue.
- The final averages that are used in the 10-min are the 5/12 EMA cloud or ribbon. In a trending market these averages are ideal for pullbacks and continuations. As long as these areas are held, you can use them as a trailing guide. I typically use this only for a trailing guide, because it is so tight to price.
Take a look at the image below, it looks very similar to the 10-min, however, it is the 5-min. In this case, you can see that the averages are tighter to price. You can see how well the 20EMA works as a guide for price.
4. Day Trading Options With Moving Averages
Now that we have the basics and the theory down, the question is how can we translate this to options? The technical analysis part is going to be exactly what we explained above. We are looking for:
- Levels based on multiple time-frame analysis
- Sentiment based on moving averages and multiple time-frame analysis
- Using moving averages as trend guides and areas we can enter/exit.
In terms of entries and exits for trading, there is something really important we need to know.
Traders SHOULD NOT use moving averages as the SOLE qualifier to get into a trade. Meaning when price comes into the 20 EMA traders should not short or long, depending on where the market is coming from. Rather use multiple other qualifiers. Such as the candlestick, volume, the level that you have, etc.
Let’s go through an example.
- This is the first pullback to the 20 EMA, is this a good area to get long? Well no, there is no trend that tells us to do so. Not to mention there is just a massive red candle that is on its way right through the level. Would really want to see a green 5-min candle close that looks bullish (doji, engulfing, etc.) The volume is extremely heavy as well.
- This is the first area where we could really say “this is a bearish pullback”. We come back into the prior lows, the 20 EMA, as well as have a nice sequence of bearish 5-min candles closing. Along with volume starting to show out for the bears, and slow down for the bulls.
- This seems like a good area right? Well yes and no, it is right into a prior resistance and the 20 EMA, along with a nice doji that prints for the sellers. However, the buy volume leading into this was purely bullish and continued to hold like that.
- Is this an area to pull back for longs? Well no 5-min green candle around the 20 EMA is disqualifier enough.
- This is a slower move from the area, but the volume as well as the candles tells us its a viable short to at least attempt.
Now that we have that broken down, how do we select our options, manage, etc?
We’ll for options selection you should be looking for:
- Short-term options, 1-2 weeks expiration for day trades.
- 25-35 delta for the options selection, higher delta for a closer expiry.
- Spreads: make sure your options spread is less than $0.10. This helps insure liquidity.
For more information on options selection please check this article out.
As an options day trader, you can trail based on the averages as well, the 5/12 on the 5-min is amazing for that. You have to be careful though, because options contracts don’t price and move like the underlying, there are a lot of different variables.
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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 for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.