The Moving Average has long been on the trading scene and has become an intrinsic part of many trading strategies. Though simple, the indicator works on almost all timeframes and with any instrument.
There are plenty of indicators based on the MA, being, in essence, the same old MA slightly alternated. This is a trend indicator, and its main task is to indicate the direction of the price, smoothing out noises and insignificant fluctuations.
Setting up the indicator
The Moving Average has several settings:
- Period is the number of bars used for calculations. It can be 1 and higher.
- Shift is the number of bars by which the period will be shifted.
- Method: there are the Simple (SMA), Exponential (EMA), and Weighted (WMA) Moving Averages.
- Apply to: close, open, high, or low.
Alternating these parameters, a trader can set up the indicator for a certain instrument and trading conditions. There are plenty of ways to use the indicator. MAs with large periods are normally used for medium-term trading. Trading intraday rather requires using MAs with periods below 100.
What it looks like on the chart
First of all, set the parameters. The smaller the period, the closer the MA will follow the price chart, mimicking the price. In the picture, we see EMA5, which means that the calculation period is 5 last bars, the shift is zero, apply to close.
If we choose period 100, the MA will follow the chart closely and sometimes cross it.
If we use a period above 100, the MA chart will move farther away from the price chart and close it rarer.
Using the MA for trading stocks
Based on the fact that the charts of stocks do not differ much from those of currency pairs, you can use the indicator without significant limitations. Market players say that “bears live under the MA200 and the bulls – above it”. This means that, in the long run, the indicator speaks about the continuation of the current trend.
There are several options of trading by the indicator:
- Crossing of MAs
- Bounces off MAs
- Breakaways of MAs.
Crossing of MAs
Here, you can trade on any timeframe but mind that charts smaller than M5 will give many false signals. M15 will be optimal for intraday trading.
What to do?
1. Choose stocks with good volatility and trade volume over 500 thousand per session.
2. Draw two MAs on the chart – EMA8 and EMA18 (these are just example settings that can be changed based on the trader’s experience), shift: zero, apply to: close.
You can also use Fibonacci settings.
3. As a signal to open a position, you can take the crossing of the two MAs: the fast one with period 8 (red) and the slow one with period 18 (blue).
Open a buying position after the fast MA crosses the slow one from above.
Open a selling position when vice versa – the fast MA crosses the slow one from below.
The trading strategy that uses several MAs is very widespread and has several setting options. In such cases, a Stop Loss is placed behind the nearest high or low. Close the positions when the MAs cross vice versa.
Bounces off the MA
For this trading option, we use only one MA with a period over 50 (it can be smaller but there will be many false signals). Choose potential stocks for trading the same way as above.
Add an EMA200 to the chart; shift zero, apply to: close, the color of your choice. As an additional opening signal, use reversal candlestick patterns from the classic tech analysis: a Hammer, Inverted Hammer, Shooting Star, Hanging Man, Doji, Engulfing, or Harami.
Open a position when a reversal pattern forms at the place where the chart touches the MA. In such a case, the indicator line becomes the support/resistance level.
An example of opening a buying position: after growth, the quotations form a pullback to the support level, which is the EMA200, and upon reaching it, form a reversal pattern Hammer. After the candlestick closes, open a buying position. Place an SL behind the low of the Hammer and a TP – behind the nearest high.
A selling position is opened alike with the only difference that the price pulls back after a decline to the MA below. Mind that you trade the overall trend.
Breakaways of MAs
The principles by which you trade breakaways of MAs are the same as for trading breakaways of t6echnical support/resistance lines. In this case, the MA acts as one of these levels. As long as the overall trend can change, open positions against it.
An example of opening a buying position: the quotations spent some time under the EMA200 and approached it from below again, breaking it away by one candlestick. After this one closed, the next candlestick opened above the closing price of the previous candlestick, which can be interpreted as a signal to buy.
Place the SL at the nearest low. As you see on the chart, the price reversed and started forming an uptrend. Close the position after the MA is broken away by the price in the opposite direction.
Advantages and drawbacks of MAs
The advantages are:
- A whole range of settings
- Applicable to all instruments
- Can be combined with other indicators
- Several MAs constitute a whole trading strategy.
The drawbacks would be:
- Many false signals on M1 and M5
- Incorrect data in flats
- Makes errors in the case of gaps.
The Moving Average has long been a popular instrument. New indicators keep being developed based on it. Using the MA with other trend instruments can increase your chances for success in trading stocks and indices in the stock market.
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