Moving averages are to classify among the most popular and useful trading indicators; you can find this indicator on any trading platform. It’s a simple but very powerful tool that you can use in your trading strategy for entry signals or closing a winning trade for example.
Essentially, a moving average is a lagging indicator (calculated with past data) it gives you an average of the price over a certain period. Even if there are many different types of moving averages; we will focus here on the normal ones called SMA (simple moving average) and EMA (exponential moving average) which gives more weight to recent prices in the calculation resulting in an indicator with a slightly different shape.
What period to use?
Commonly, traders use a lot the 10, 20, and 200 periods MA (for longer term trading). These are just guidelines so keep in mind it is not an exact science and you need to adapt to the market / timeframe you are trading: A good way to find accurate moving averages is to simply try different ones and check which one gave good result in past data. By good results here we mean a MA that supported a trend successfully by rejecting the price each time it has been tested or a MA that triggered nice swings each time it was broken.
The below chart of the DAX 15 mins shows that MA 65 was really accurate in supporting the bullish move:
Entry Signals with Moving averages
The idea here is to wait for a shift in the trend and play the reversal of the market, this kind of entries are obviously counter trend (even if they can be in the direction of the primary trend) but can provide good risk reward ratio when a nice move is triggered by the breakout of the moving average.
As explained before you first need to find an accurate MA on the market you are trading, then wait for the market to break above or below the moving average and go long or short. Whatever timeframe you are trading, the breakout is considered valid and the signal is triggered once the candle closed below or above the moving average. This is to avoid fake signals when the market breaks temporary the moving average but then closes with a Pin Bar and doesn’t confirm the breakout, it also help to make sure the market is strong enough to reverse or trigger a new trend. You can trade with moving average breakouts whether you are scalping, trading intraday or swing (long term).
The below chart shows a few examples of MA breakouts on the EUR/USD (1Hour timeframe with MA35):
The Crossover entry also called crossover strategy or golden cross uses two different moving averages: a fast one generally exponential with a small period such as EMA 5 and a slower one with a bigger period for example MA10 or MA20.
The entry signal happens when the faster one crosses the slower one: in this case when EMA 5 crosses MA20. The idea is similar to the breakout strategy; we wait for the existing trend to bottom and play the new trend developing after the crossover with a good entry point.
These entries can be extremely reliable when looking at bigger timeframes: (h4, daily weekly and monthly) and can also give you a good confirmation to stay in position if you took a trade early and the crossover happens afterwards. When looking at shorter timeframes crossover can lead to many fake signals this is why you should avoid trading this setup on timeframes below 15mins.
The below charts shows examples of crossover on gold (daily timeframe, ema5 and ma10):
So far the setups we discussed were dedicated to breakouts or reversal strategies, if you are part of the traders who prefer to buy supports and sell resistances moving averages can help you too!
Indeed, another method is to use Moving Averages as a dynamic support / resistance for entries when a trend has developed already, in this situation the market already broke the Moving Average and trades below or above it.
Each time the price tests the MA and gets close to it the idea is to go long / short according to the direction of the trend to play further bullish or bearish extensions. This setup has numerous advantages:
-You always trade with the trend
-The SL can be sized easily slightly below or above the MA which means good risk management and good Risk / Reward
-The entries provided by the pullback are usually the best way to jump in a trend
Examples of a MA pullback on the Dow Jones H1 with MA 20 and Ethereum H1 also with MA20:
How to close a winning trade with Moving averages?
Beginners in trading usually think that finding entries is the hardest part of the job…well it’s not! The more you trade the more you will face situations where you had a very good entry point but you closed the position way too early or way too late : you missed profits and you didn’t make the most of the trend. Guess what? Moving Averages can give you the answer when you wonder whether to close a trade or not.
Indeed, as long as the market remains below or above the MA you can be confident the trend is intact. As soon as the price breaks above or below the MA (MA breakout), you know the momentum is shifting and a potential reversal can take place…This is the perfect timing for you to close your position and take profits regardless of how many points / pips you are making. Here we basically use the MA breakout to manage the exit instead of the entry.
The main benefit is the great flexibility it brings compared to a normal Take Profit: You never know how far a trend can go, by using the MA breakout to get out, you may close a lot of trades after few pips but once a strong and powerful trend develops you will ride the whole of it and these few big trades will make the difference in terms of performance on your account at the end of the year.
To finish, you can make this even more efficient by trailing your Stop Loss below or above the Moving Average while the trend keeps going. This allows you to secure some profits and protect against a big reversal that would take too much of your P&L out.
False signals, how to avoid them and the importance of risk management
In every single trading strategy you will have the risk of getting fake signals (because there is no such thing as a 100% winning pattern); the important part is to understand when the fake signal is most likely to happen in order to do everything you can to avoid them.
We understood that MA entries, and generally speaking Moving averages setups, are effective when a decent swing or move is triggered from the signal. On the other side when the market trades in a tight range these entries can lead to many fake signals. This is why every good trader knows and understands the market he is trading, specifically the hours when the market is really active and when trends can develop, and the hours when the market is a bit more quite which can lead to the development of ranges. One example can be the opening session on indices: it’s well known that indices usually start the session with a lot of activity when the market opens and become more quite before closure of the market.
It’s also important to keep in mind that in trading nobody (or no indicators to be specific) reads the future and Moving Averages are NOT a holy grail, you should use them wisely while managing your risk properly: trade small to not put your account at risk!
We will release soon an article dealing exclusively with risk management, Stay tuned!