How To Properly Use Moving Average In Trading?

Importance Of Price As An Indicator?

Let us start with the basic and conclude with some advanced method of using moving average. The first that you should know about the market or stock and is the price. There are traders who make their first opinion about the market or stock by watching indicators like RSI, Stochastic, MACD, CCI, SAR, MFI, PVT. Or even they first watch 52 weeks high/low or financial result, balance sheet, book value, dividend, EPS, P/E ratio etc. But in reality, all these is the secondary information and not that much important as the price and its current direction itself. Because the final result or essence of all of the information is contained in the one indicator that is “Price” itself.

Irrespective of the fact that traders around the world use various information for their trading decision; Only one thing is common to them. All traders watch price before entering a trade, they watch price during the position and also before exiting from the trade. Because ultimately the price dictates their profit or loss in particular trade, not any other indicator or financial news. Also, people’s emotion depends on profit or loss in particular trade, and the profit or loss is decided by price and price only. That is why the price is the most important indicator for trading decision.

Also, people’s emotion depends on profit or loss in particular trade, and the profit or loss is decided by price and price only. That is why the price is the most important indicator for trading decision.

Price is the latest news in the stock market. It shouts all the time about the underlying strength or weakness in market.

Understanding Moving Average

Even with such vast importance of price, it is difficult to use it in the trading decision. We find that price is very volatile. All the time the price moves up and down and seems very random in movements. But still in this random like movement of price, most of the time there is a directional bias. This bias of price that takes it in one particular direction, is due to its trend. This general trend can be short term or long term depending upon the time frame that we use.

Most money is made trading in the direction of trend and the dreadful truth is that the opposite is also true.

This general trend of price can be found by use of moving averages over and above the manual method like trend line, trend channel or positions of the swing high and low. The moving average not only filters the randomness in price but at the same time respond to the general direction of the price trend.

Different Types Of Moving Averages And Calculation:

In our general life calculation, we use average which is simply an average of all the data under calculation. But when we are dealing with a very volatile data and we want to follow its direction we can’t use this static average. So we use the average of last decided period and update it with by adding latest data and simultaneously removing last data. This type of average calculation is called simple moving average. Because the average itself also update with the addition of latest data and try to follow the general direction of data. But still, it is an average of last n period of data so it will be less volatile and more smooth.

There are also various types of moving averages also. Like simple moving average that uses the calculation method we just discussed. The other types are triangular moving average that put more emphasize on middle data. Exponential type of moving average emphasizes more on the recent data and less on past data so it more closely follows the recent trend of the market. Due to the property of adapting to the most recent data, the exponential moving average is more popular and useful in technical analysis. There is also two variation in EMA that is double exponential moving average(DEMA) and triple exponential moving average(TEMA).

How Much Period Setting To Use In Moving Average?

How much period to use depends on your trading style. The lower period you use the more volatile will be the moving average. The higher period will give you the smooth line but it will give you lagging indication of a trend change. I suggest not to use very fast period anything less than 10, particularly for the price. Because it will give you more whipsaw with the price. The best period for short term moving average is around 20 and medium term MA is around 50 and long term MA period is around 120.

All this number may seem like for long term. But we can adjust the time frame if want to trade in the shorter timeframe. For example, if we use the above period in 5-min chart it will give us intraday trends, if we use same with 15-min chart it will give us swing direction for swing trading. And the same EMA in the hourly chart will give us medium term trend and long term trend with daily charts.

Various Indications Given By Moving Average For Market Or Stock

The very first indication is moving average line itself if the MA line is rising it indicates that the trend of the market is up, and if it is going down it means the trend is down and if it is going horizontally it suggest sideways market. The position of price with respect to the MA also provides a very good indication of price momentum right at the present time. If the price is above the MA it indicates the price momentum is in up direction. And If the price is below MA then price momentum is in the down direction. Also if the price is frequently moving above and below MA line then it indicates no momentum in price.

If we draw two moving average on price chart with the different period. Then the MA with the lower period is called fast MA and the large period MA is called slow MA.

If Fast MA > Slow MA than it indicates uptrend.

If Slow MA > Fast MA than it indicates down trend.

We can also use 3 MA to filter signals with respect to the long-term trend. When 3 MA bunch together it suggest that the market is under balance and creating a horizontal pattern.  And also it is about to break out of this horizontal pattern. And this will give us very good trending moves.

Chart Example For Moving Average Indications

The above is the daily chart with three different moving average on price with setting 20, 50 and 120 respectively. In this chart the following four points are worth noting:

1. The green line is higher period EMA(C,120) is always rising indicating that the long-term trend was always bullish. While the white line EMA(C,20) is frequently rising and going down indicating the change in short-term trends.
2. Mostly when price close cross above the white line EMA(C,20). The price gains momentum in up direction as we discussed in the previous paragraph.
3. When white line EMA(C,20) cross above the blue line EMA(C,50). It gives an indication of the uptrend in the medium term and vice versa.
4. Near the edge of the triangle pattern, all three lines (EMA(C,20), EMA(C,50) and EMA(C,120)) bunch together. This gives an indication that the market is under balance and pattern is about to break.

All the above four moving average indications are useful enough for getting the insight of price trend in all time frames and also in all (short, medium or long-term) terms. The moving average crossover may give the false signal when the market is sideways. To find when the market is trending or sideways watch this post and video.

In the next post, we will discuss one trading strategy based on moving average crossover with backtesting results.

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