How to trade the moving average channel

 

Moving averages are the indicators that just keep giving – the different ways you can apply them really are endless.

Markets can often be messy – they don’t turn exactly on our neatly drawn support and resistance lines, but tend to consolidate around them. This can lead to a lot of false signals as candlesticks poke their heads through key levels.

Moving average channels allow for this ‘vagueness’ by giving our moving averages an ‘area’ rather than a single line.

They look something like this …

Here’s how we apply the moving average channel to a chart …

We add in two moving averages based on the same period, but using the candle high for one and the candle low for the other …

Standard moving averages are usually built from the close prices of each candlestick, but in this case, they are built from the high and low prices of each candle. The result is a channel, which is more forgiving that a normal moving average, and gives us better scope for confirmation of trends. A lot of messy sideways action – the nemesis of the trend trader – is filtered out.

Let’s say that we’re going to trade the moving average channel in this way …

• Go long when a second candle closes to the upside of the upper boundary of the channel. Close a long trade when the price closes below the lower boundary of the moving average channel.

• Go short when a second candle closes to the downside of the lower boundary of the channel. Close a short trade when the price closes above the upper boundary of the channel.

On the chart below this would see us buying at A and closing at B for a profit …

That’s all well and good, but trades like ‘A’ to ‘B’ on this chart are pretty basic fodder for a trend-following tool to pick up – that’s the easy money.

What matters is how our trend-following tool deals with the more messy price action that follows. This sees us getting into a long position again at C, which is taken out for a modest loss at D.

By using the channel, we filter out a lot (but not all) of the sideways action, but when we do get into a bum trade – our stop level at the far side of the channel takes us out quickly for a small loss.

The same exit strategy conversely allows a strong trend to run and run before taking us out.

By using the moving average channel as an exit tool, we’re making ‘cut losses fast and let profits run’ an integral and automatic part of our trading.

Building a moving average channel strategy

I don’t recommend using the moving average channel alone for a trading strategy. In particular, I’d want my trade entries to be faster and have some momentum indicator to trigger them. However, as bare bones this has a lot going for it. By using the channel rather than a single line, we’ve automatically eliminated a lot of ‘chop’, making this a very powerful filter to add to a trade signal. And, as we’ve seen, the channel works particularly well as an exit indicator.

I look forward to hearing how you’re using the moving average channel in your own trading.

 

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