The secret to a long and happy relationship with your technical indicators

I’m currently putting together a video that I really think you should watch.

It’s an update on how one of my favourite trading strategies from last year has been faring.

It’s not had a losing month, and has made over 100% return in the last 9 months!

I’ll be posting the video next week – so please keep a look out for it.

Getting started

I know that following last week’s email, a number of bulletin readers have taken their first steps into the world of trading, with the help of that £100 starter, and my dead simple moving average trading strategy.

If you’ve been trading for a while, you may already be very familiar with moving averages, and how helpful they can be.

A really good technical indicator doesn’t muddy up your price charts with extra information – it simplifies the chart.

And, once you’ve made friends with a moving averages, your charts will start to look naked without them!

Traders often ask me which is the “best” moving average.

Should I be using a 10-day moving average or a 12-day moving average?

Is an exponential moving average better than a simple moving average?

The truth is that it really doesn’t matter too much. The most important thing with moving averages (in fact, with all technical indicators) is to pick one you like, and stick with it.

No indicators are perfect – they all have their strengths and their weaknesses.

If you’re constantly chopping and changing, you won’t give yourself a chance to know what those strengths and weaknesses are. But if you stick with what you know, you’ll find that you build up a relationship with your indicators – you’ll know when they’re giving you good information; and you’ll learn when they might be giving out mixed messages.

And when you understand their foibles, you can be very forgiving of those times when your chosen indicator gets it wrong.

So, if you’re interested in hooking up with a technical indicator, you could do a lot worse than a moving average – she may have been around a bit, but she’s flexible, dynamic and dependable.

What’s in a moving average?

A moving average is one of the most basic technical indicators you can get. It’s not full of whistles and bells, but that means that it’s very easy to understand.

All it is is an average of prices over the period that you specify. If you want a 20-period moving average – you’ll get the average price for the past 20 periods plotted onto your chart. If you want a 200-period moving average, you’ll get the average price for the past 200 periods plotted onto your chart.

A moving average can’t tell you anything about the future, but instead gives you a smoothed-off picture of past prices. It takes out all the “noise” – giving a more general picture of market sentiment.

The longer your moving average (ie the greater the number of periods you’re looking at), the smoother it’ll be, and the slower it will be to react to change.

Longer averages are more serious

The longer the average, the fewer times the price will retrace to it, but the more significant it is when it does penetrate. For example, the price will test or penetrate a 200 period average far less often than a 20-period moving average. But breaking a 200-period average is far more significant.

Many traders and investors will view the penetration of a long-term moving average as a major turning point for price behaviour, and this can lead to a big change in market sentiment.

Longer averages suffer from lag

Because moving averages are based on past prices, a longer average will pick up a new trend more slowly. This is called its “lag”, and it means that as a trader, if you’re following a long average, you may have already missed much of a move.

This may not be a problem if you’re trading on longer timeframes, but if you’re after quick profits, you’ll need the faster reactions of shorter moving averages.

Matching your moving average to your timeframe

Any test or break of a moving average will be more significant if you’re looking at a longer timeframe (such as daily or weekly charts) rather than on shorter timeframes (like 5- or 15-minute charts).

If you’re looking at longer timeframes, and longer-term trends, you’re going to be naturally drawn to slower moving averages (those over a longer period). A short-term trader will find that 5–20 MAs are best suited to their needs. A medium-term trader might be looking at 20–60 periods. And longer-term investors will be interested in moving averages with 100 or more periods.

Certain moving averages are very popular and will naturally have an effect on the market when they are hit or breached. Top of that list is probably the 200-day moving average, with the 50-day average coming next in popularity.

Strong trends cause moving averages to cross

When the market starts to move, we see moving average crossovers, which are often used by traders as confirmation of a trend and as a signal to trade. (As in the strategy we looked at last week.)

One of the most effective demonstrations of this can be seen in a “moving average ribbon” which shows the moving averages cascading through each other …

Pretty, isn’t it?

Know your EMAs from your SMAs

An EMA is an exponential moving average. It’s often lauded as a more “intelligent” or “sophisticated” version of a simple moving average, but I think it’s worth pointing out that the calculation for an EMA is simpler than that for an SMA, which may be why the EMA became popular (in the days when people had to do the sums for themselves!)

(To calculate an EMA, you just need yesterday’s EMA and today’s new closing price. For an SMA, you need to have every closing price for the period you’re looking at.)

Whichever is really the “simpler” version can be debated, but the key difference is that an EMA applies more weight to recent prices than old ones, and this can often be helpful to the trader. The EMA will have less lag, be more sensitive to price moves, and will react faster than a SMA.

Keeping it simple

Moving averages are a great starting place for technical traders, and many other indicators are built on them, such as Bollinger bands and MACDs.

But the trading technique I’m going to be talking about next week, has done away with all technical indicators.

Instead, it’s spotted a price action that repeats itself consistently, and has found a clever little trick to take advantage of it.

It’s a bit like cheating.

But, what’s important is that it has worked consistently.

And it proves that successful trading strategies have more to do with watching market behaviour for patterns that occur again and again, than with building ever-more complicated combinations of indicators.

Profitable trading doesn’t have to be complicated (we’re not trying to break the bank here – we just want a little slice of profits for ourselves). But it does need to find an edge and use it consistently, again and again.

I’ll bring you all the details next week.