3 smarter ways to use moving averages

Moving averages fall into the category of lagging indicators.

This means that they give you your signal after the price action has happened … so, they’ll tell you that a new trend has formed … after that trend is showing up … or that the price has change direction … after it’s turned …

So, they tell us what’s happened … after it’s happened. And that’s the reason that many people discount moving averages and lagging indicators in general.

But it’s a mistake to ignore these indicators because of this weakness.

And this is why …

1. Leading indicators (as opposed to lagging ones) sound like a great idea – they should get us into trades sooner. But they’re always trying to preempt market moves, so they’ll often get it wrong. Lagging indicators, by contrast, don’t jump in at the first sign of action. Instead they wait until a market direction has formed.

Yes, this can mean missing the boat, but if you match your moving average to the timeframe you’re trading, and you match it carefully to other signals, a lagging indicator can be a much more powerful and reliable tool.

2. Lagging indicators give us important information about sea-changes in trader sentiment. If we have a significant moving average crossover, for example – you can be sure that you’re not the only one who’ll have spotted it, and there will be an army of buyers or sellers putting their weight behind that price move.

I’m a big fan of moving averages, but I’ll be the first to admit there are some things they are terrible at – like catching new trends early or coping with sideways markets – but if we focus on their strengths and use them the RIGHT way, they can be a powerful money-making tool.

But first, let’s get a feel for moving averages and what they are telling us …

A simple moving average is created by adding up the closing prices of ‘x’ number of periods, then dividing the result by ‘x’. So, a 200-day moving average is the average closing price over the last 200 days; the 50-day moving average is the average closing price over 50 days … and so on.

The lines these figures plot on our charts show us overall trends with the daily noise taken out of them. A 20-period moving average will show us the short-term trend; the 50-day moving average will show the medium-term trend; and the 200-day moving average will show us the long-term trend.

The standard ‘wisdom’ is that if the price moves above the moving average, we have an up trend, and if the price moves below the moving average, we have a down trend.

The fewer the periods the moving average is measured over, the more reactive it’ll be to price. This can be useful if you want to catch a short-term trend quickly, but if you’re interested in riding a long-term trend, then a fast moving average is like to give you too many false signals.

Take a close look at this hourly chart showing both a 20-period MA and a 100-period MA. Look at where it would have given you good signals and false signals over different timeframes …

It’s important to get a good feel for the sensitivity of a moving average that you use – and that means watching it closely and keeping track of when it gives good readings, and when it gives false readings.

But, like any technical indicator, moving averages don’t work well in isolation – they need to be part of a bigger trading plan. Yes, we can add another indicator, but here I want to look at methods that really play to the moving average’s strengths – because this is the way to reap the biggest rewards in our trading …

1. Long-term crossovers ahead of the trigger

Moving average crossovers are a signal given when two moving average lines cross.

If the faster MA crosses above the slower one, it’s seen as a buy signal. If the faster MA crosses below the slower one, it’s seen as a sell signal.

Long-term crossovers carry more weight than short-term ones. And the ‘daddy’ of moving-average crossovers is that between the 50-day moving average and the 200-day moving average.

When a 50 MA crosses above a 200 MA, it’s known as a golden cross. When it crosses below, it’s known as a death cross.

Here we can see a 50MA (the green one) crossing above a 200MA (the red one) on a 4-hour AUDCAD chart …

This powerful signal tells us more than just ‘what’s happened’ – it suggests a change in trader sentiment that will continue to push the price upwards.

Add to this very bullish signal, a break above a long-term triangle formation – and we have our trigger for an entry to a buy trade. As we can see, the price has spiked through the triangle before, but this time it forges through the resistance with momentum.

This is an example of using a moving average crossover to guide us in the overall direction of the trades we’re looking for. There’s no doubt that the price had to break this triangle at some point, but the crossover tells us that this move is going to be sustained rather than just a false break.

2. Dynamic support and resistance

Support and resistance levels – the horizontal lines on our charts where prices have stalled or turned in the past – are one of our best predictors for price behaviour.

But sometimes we can find ourselves in new charting territory without these levels nearby to guide us.

So, how can we always have a level covering our backs? Something to guide us on where to put profit targets and stop levels?

The answer is moving averages …

Moving averages provide an excellent safety value for trend followers.

When we’re trading a trend, pullbacks can be a killer. We want to ride the trend for as long as possible, but we don’t want to give our profits back by hanging on when the market has turned.

Wouldn’t it be useful to know how far a pullback will retrace?

Take a look at how the price in a trend neatly bounced off the ‘danger zone’ marked out by the 10 and 20 MAs on this 15-minute chart …

Once we’re in an established trend-following position, we can use this ‘bounce’ to stay in the trade (or to jump out if the retracement looks too severe).

3. Moving averages and mean reversion

Mean reversion traders function on the principle that prices will always move back to their average.

Moving averages measure the average price over a set time period …

Therefore moving averages can be used to measure overbought and oversold signals, with the MA line itself acting as a magnet for that price to come back to.

On the image below we can see the powerful pull of the 20MA on the price, giving a dynamic profit target …

But how do we trade this? Sometimes prices will deviate a long way from the moving average, and sometimes they’ll stay close by … without relying on a huge stop loss, how could we predict when we’ll get a reversion to ‘the mean’?

The most obvious way is to add Bollinger bands to our moving average.

Bollinger bands are two extra channels either side of the moving average, based on an average deviation from that central line. They look like this …

Sometimes the Bollinger bands will be wider … sometimes closer together. But, what we see in the chart above is the price turning when it hits a Bollinger band, and being drawn back by that magnetic pull of our 20MA.

The great thing about this method is that it allows us to make money from moving averages even when they are flattening out and the markets are directionless (normally a time when moving averages give the most false signals).

However you use moving averages in your trading, I hope you’ll see that weaknesses in an indicator don’t make it worthless – in fact, where weaknesses are most obvious, they can be more easily skirted around. That way, we can play to the strengths of our own strategies, and enhance our success.

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