Trading 101: Moving Averages and Moving Average Strategies

What are Moving Averages?

Moving Averages are among the most popular trend indicators in Technical Analysis. They provide a simple, yet powerful visualization of the ongoing trends in an asset. They are used for a wide variety of reasons, primarily for trend following and reversal strategies.

Simply put moving averages are connected points calculated for every day (or whatever the timeframe is). The calculation itself is simple; you take a given number of previous days and calculate their average. Of course, you don’t have to do the calculations yourself. All basic charting software and trading platforms do the math for you and plot the moving average (or up to dozens of averages for that matter) on the chart of the asset.

How to Interpret Moving Averages?

If you want to know what a moving average means, just think about that it is nothing else but a smoothed way of describing the price movement itself. So, if the MA is rising that means that the price trends upwards on the given time-frame. It is that simple. Also, if the current price is above a certain MA that usually means that the trend on that time-frame is still intact.

Now the interesting part is when you use the MAs for comparisons. You can compare two MAs with different time-frames or simply compare the value of the MA to the price itself. This might be helpful for plenty of reasons, but the most important conclusion that you can make is the alignment of a short-term and a longer-term trend. Like this, you can spot trend reversals, pull-backs, and exact entry and exit points. How? Let’s see some examples.

How to use it Trading?

Moving averages can be used in virtually unlimited ways, but as always, keeping your strategies simple is advisable. So let’s see the basic but most robust applications:

1.     Determine the ongoing trend by comparing the price and a certain MA, and its direction.

This is as simple as it gets; first, you take the direction of the MA, then you take a look at the price and see whether it is above or below the MA. If the MA is rising and the price is above it then it is confirmed up-trend. According to that, you should only trade on the upside on that particular time-frame, as trading against the trend is usually not a wise thing to do. So, to take an example, you can see a clear up-trend on the chart below with the 200-day MA rising all along.

The simplest strategy is to go long when the price crosses above the rising moving average, and sell the position when it crosses below it (this works of course with a declining MA and a short position, but with the price crossing below the MA).

Moving Average Strategy 1.

2.     Compare two different MAs for determining the trend and reversals.

The second, and probably the most popular strategy for moving averages is the so-called “cross-over” strategy.  The steps are similar to the first strategy; just instead of the price, you use a short-term MA as the “trigger” for the trades, as you can see it on the chart below. A lot of traders use the additional condition that the long-term average must be advancing for this strategy.

Moving Average Strategy 2.

3.     Identify pullbacks to enter trends more precisely.

This approach the most advanced of these simple strategies and it can be helpful to capture a larger portion of market “swings” than the two prior frameworks. The idea is to take the conditions of the first or the second strategy but wait for a pullback before actually entering the trade.

But what does a pullback mean? Well, that depends on the interpretation, but the basic definition is for the price to touch the given MA in the case of the first strategy. As for the second strategy, a useful way of defining a pullback is to wait for the price retrace to between the short and the long-term MA, just as you can see it on the chart below. This way you will enter to an already established trend with the additional benefit of not getting in a short-term overbought position.

Moving Average Strategy 3.

When does it work?

As it is the case with every indicator, moving averages have their strengths and weaknesses. By knowing when to use these very useful indicators you can avoid the common mistakes that traders make. The most important thing is that MAs work the best in trending markets.

On the contrary, in sideways price action, these averages can give false entries or cause overtrading through too frequent signals. Applying the direction of a longer-term MA as a condition (for example having a rising long-term MA as a requirement for long positions) can be helpful to prevent these problems.

Also, it’s wise to wait for confirmation before entering a trade. As an example, if you are entering a trade using the first strategy, wait for the second close above (or below for a short position) the MA before “pulling the trigger”. This way you can steer clear of “price-spikes” that are an integral part of the forex and cryptocurrency markets.

Featured Image from Shutterstock

Author:
Trader and financial analyst, with 10 years of experience in the field. An expert in technical analysis and risk management, but also an avid practitioner of value investment and passive strategies, with a passion towards anything that is connected to the market.