The secret to the best moving average combinations

The question traders always want the answer to is: Which way are prices moving?

The simplest and (arguably) the most effective way to measure this is with moving averages.

Moving averages show us the average closing prices across a range of candles. The higher the number of periods we use in the calculation, the smoother our average line will be.

Here we can see the 10-period moving average is much more jumpy than the smoothed out 50-period moving average …

But with thousands of moving average settings available … how can we know which are the best moving average combinations to use?

How many moving averages to use

The first question is: Just how many moving averages do you need?

One, two, three, or a whole ribbon of them …

If you use just one moving average, you have limited information – the price is either above the moving average (signalling an uptrend), or below it (signalling a downtrend). It’s a trend up/trend down binary option.

And if the markets are choppy, a single moving average can make reading signals quite confusing …

By adding in a second moving average, we can get two smoothed out lines, and see how they move in relation to each other …

The added ‘smoothing’ effect of a second moving average immediately makes the trends easier to spot.

But we still find ourselves in a binary situation – the trend is either up or down.

By adding in a third moving average, we can be more demanding … this enables us to filter out situations where the trend is just not clear enough.

In the example above, we’ve got three moving averages to measure trends. If the 12 is above the 30, and the 30 above the 50, then we’ve got an uptrend. If the 12 is below the 30 and the 30 below the 50, we’ve got a downtrend. If they aren’t neatly stacked like this, then the trend isn’t considered to be clear enough.

I’m a fan of the third moving average, as it gives us much more effective trend filtering, with three distinct market phases: trend up, trend down, and (crucially) no clear trend.

Adding in further moving averages has debatable value, unless you’re looking for a very specific purpose.

How many periods to set them at

The next question is: What value should your moving averages have?

When picking the number of periods for your moving averages, there are some important considerations …

• Are you looking for long-term trend direction? If so, consider the classic long-term measures of 50, 100 or 200-periods. The crossover of the 50- and 200-day moving averages are considered a key indicator of bear and bull markets. But even if you’re trading on shorter timeframes, these levels will give a solid background to trend direction.
  
• For shorter-term direction, consider a combination of moving average settings between 5 and 50. At the faster end of this would be: 5, 10 and 20. Or at the smoother end would be: 15, 20 and 50.
  
• Some traders prefer to go for Fibonacci numbers for moving averages, like: 5, 8, 13, 21 …
  
• Are you using moving averages for support and resistance? Prices will often bounce off major moving average levels, so if you want to employ this in your trading, pick significant (and popularly used) levels, like 20, 50, 100 etc.

Which type of moving average is best?

The simple moving average is just that – an average. But there are plenty of specialist moving averages, which will either add in extra smoothing, or put extra weighting on more recent data.

The chart below shows the simple moving average (in red) and the triangular moving average (in purple).

The triangular moving average is a moving average of the simple moving average values. It’s calculated as: TMA = (SUM of SMA values) / (number of periods)

As you can see, the result is a smoothed out moving average line.

Another category of ‘special’ moving averages are those that give more significance to the most recent prices. These include exponential moving averages and weighted moving averages – both of these give an extra ‘weight’ to recent data.

Here’s how they look on a chart (simple moving average in red; weighted moving average in blue; exponential moving average in purple)…

You’ll notice that the EMA reacts most quickly to price changes, because its ‘weighting’ is more significant than the WMA; with the simple moving average lagging behind both of them.

My advice is not to sweat the type of moving average too much. If your moving average is too jumpy – consider using a longer period, or adding some smoothing. If you want faster reactions from your moving average – consider using shorter periods, or using a weighted moving average.

Pop three moving averages you’re considering on a chart to test how they work – there’ll always be an element of playing around to find what suits you best.

 

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