What is a Moving Average?
A moving average is an indicator that takes into account past price points in order to overlay an average price on the chart. The slope of the moving average is used to identify the prevailing trend, whereas a flat moving average might indicate a market without a trend.
Another important characteristic of the moving average indicator is that it usually acts as a dynamic support and resistance line. Price will usually respect it and will bounce back from a moving average or cross through it and change the direction of the prevailing trend.
Different Types of Moving Averages
There are different types of moving averages based on the way the values are calculated. The most common ones are the simple moving average (SMA), the exponential moving average (EMA), the weighted moving average (WMA) and the smoothed simple moving average (SSMA).
The exponential moving average usually places more emphasis on recent price movements while the weighted can be adjusted to the user’s preference. However all types do point to the prevailing trend regardless of calculation and can be used for entering and exiting a trade.
Different Period Moving Averages
By using two moving averages with similar calculation but of different time periods we can get a better feeling of the prevailing trend, as well as time an entry in a trade.
In our example we’ll be using exponential moving averages (EMAs) which are normally available on every trading platform. The first EMA with red color will have a time period setting of 100 and the second one with green color will have a time period setting of 14. The 14-period EMA is the fastest as it responds quickly to changing market conditions, while the 100-period EMA is the slowest and it indicates the direction of the prevailing trend.
The 2 Moving Average Strategy For Trading
A strategy using two exponential moving averages is quite uncomplicated to implement and has the potential to help traders to decide both on the market direction and the optimal timing for an entry. When using this strategy, traders need to watch out for a sequence of signals.
The 3 critical conditions for a long trade
- The asset price and the 14-period EMA must both cross above the 100-period EMA and stay above
- Price then needs to come back lower and touch or re-test the 14-period EMA. This can be either a soft re-test with the body or the wick of the candlestick or a candlestick crossing through the EMA and closing below. This is critical because it will enable getting on a trade at a better (lower) price.
- The final touch is to wait for the first bullish candlestick to open and close either below or above the 14-period EMA. It is preferable to close above, but closing below will enable a trader to enter the trade at a lower price which increases the profit potential. Once this candlestick closes, a long trade can be initiated immediately.
The 3 critical conditions for a short trade
- The price of the asset and the 14-period EMA must both cross below the 100-period EMA and stay below
- Price then needs to come back up and touch or re-test the 14-period EMA. This can be either a soft re-test with the body or the wick of the candlestick or a candlestick crossing through the EMA and closing above. Again, it is important because it will enable getting on a trade at a better (higher) price.
- The final touch is to wait for the first bearish candlestick to open and close either above or below the 14-period EMA. It is preferable to close below, but closing above will enable a trader to enter at a higher price which increases the profit potential. Once this candlestick closes, a short trade can be initiated immediately.
Moving averages are very easy to use and combine with price action in a trading strategy. The time period and calculation method settings can be adjusted to the preference of the trader and the characteristics of the trading asset.
Standard strategies using 2 moving averages usually have only one criterion. Enter a long trade when the fastest moving average crosses above the slowest and enter a short trade when the opposite happens. What happens though is that this leads either to entering a long trade at a very high price or a short trade at a very low price, reducing profit potential. Even worse, this leads to false trades as very often the price will make a complete turnaround after the moving average cross.
By waiting for the price to come back and then waiting for the first candlestick to close in the direction of the moving average cross we can avoid all the major pitfalls of the standard strategy and increase the probability of success. This also enables a tighter stop loss in the case of a false signal.