So what exactly is a moving average ? Well, the moving average can be several things. A simple moving average is the average of some value of the last X candles, this last value can be the opening price, closing price, high, low or any other operation of price during that candle, like the median price. For example, an 8 period close simple moving average is simply the sum of the closing price of the last eight periods divided by eight. Now, this value is calculated for each candle and ploted on the screen giving us a moving average line on top of the instrument’s chart.
What does the moving average mean ? It is really just the average of price movement over the past X candles. Why is the strategy to go long when price goes above the moving average and to go short when prices go below the moving average ? This is because when price goes over the average of the past X periods it means that price is doing a “breakout” over it’s previous average price, it certainly means that price is moving away from it’s previous average values. This of course as you know, is a strategy that would wipe your account since moving average strategies would suffer from what most people would call whipsaws. That is, price tend to move above or below a certain average of previous prices only to return to the average because the average price after all, is the price the instrument has been traded for in the past.
Another important matter is the moving average period. How many periods back in time should we average ? 10,20, 4, 100 ? Well, the more periods you average the harder it will be for price to break over or under the moving average as you are taking into account a longer period of time. So for example, a 200 period moving average on the daily chart catches 2 to 3 year long trends and is therefore a powerful strategy by itself since prices tend to whipsaw little on such large timescales and periods.
The moving average, as you may know or have infered by now, is a trending indicator, that is, it works very well when the market behaves in a directional manner because prices tend to stay above or below their averages during a trend. However, prices tend to cross their averages constantly during consolidation and ranging periods so you will lose money overall. How can you improve the moving average ? Is there a way to make it a better indicator ? With what other indicator can we pair the moving average to make a strategy ?
The first questions is probably answered with a little instinct. If we are guiding ourselves by the crossing of a moving average, it is an awfully lagging strategy since sometimes prices move away from their averages and when they cross back you are already a million years behind price action. What if we traded the derivative of the indicator ? That is, what if we traded the slope of the moving average instead of the actual crosses of the moving average ? For example, when prices are moving down, the average tends to decrease as each periods brings in a lower price, if we calculated the change of the moving average in time we could then plot an indicator that showed us if the change was positive or negative and we could enter a trade using this which would of course lag much less than the moving average. I am, of course, not the first person to come up with this idea and this is why the Trend Analysis Index Indicator was created a while ago. It plots the derivative of a moving average and gives you a much better sense to trading than the regular moving average indicators.
Systems with moving averages then have very strong limitations, by themselves, moving averages provide little potential for long term profitable systems unless long periods on large timescales are used, such as the 200 daily moving average system. If you trade any smaller scale, or try to scalp using a moving average (or several moving averages, being them weighted EMAs or whatever), you are absolutely doomed because the profitability of your signals will definitely change with time as the random events that generate price on the small time scales changes (and so will the crosses of your moving averages and therefore signals). This is why many people find that a great scalping system that uses a 5 min SMA is unprofitable but very profitable with it’s signals reversed and then when they trade it with the reversed signals it kills their account because the market has changed again.
Moving averages however can be paired with certain indicators to enhance their performance. If you give it a little bit of thought several different pairing options apper. Moving averages only work on trending markets so you would need to find a way to filter markets where they will whipsaw, of course, there is no way to do this 100% but there are some indicators we can use to do this. For example, oscillators (next indicators on the indicator series of posts !) can be used for this purpose (again, more on this on the oscillators post). Also volatility indicators and volume indicators can also be used for this purpose. Trading moving average crosses on high volume is certainly a way to improve their accuracy since profitable trades with moving averages usually only occure when there is a large amount of volume in the market.
I hope this post has taught you a little bit about moving averages and how they can be used to effectively trade the market. Maybe this will give you a few ideas to further develop or enhance your current trading systems. Of course, if you would like to know what types of strategies are long term profitable, how to evaluate strategies and how to trade with a profitable trading system please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed this article !