Moving Averages (iii)

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Moving averages (ii)

Moving Average Crossover – Price moving Across the Moving Average

The most basic type of crossover is when the price of The Market moves from one side of a moving average to another. When price closes below the moving average, this may suggest the start of a downtrend (within your trading horizon) and a trigger to sell may occur. When price closes above the moving average, this may suggest the start of a up trend (again, within your trading horizon) and a trigger to buy may occur. 

Your chosen time frame depends on your trading style and the system you employ. For instance, if you're a position trader where you plan to stay in a trade over a few months then you may execute trades from a daily chart using a 50-period moving average. In our Lennar Daily Chart example below we can see that when price crosses above the 50-day simple moving average a buy signal is produced. 

Simple Price Crossing Moving Average System

This is a simplistic view for now and further on in this notepad we'll discover how to utilise further T.A in your system as well as looking at setting targets for our trades.  However, a simple sell trigger may occur when price crosses back below the 50-day SMA sometime in the future (not shown in this example). 

In our above eg. we're looking at a daily chart (where each candle represents a days price action), but the same trigger will apply if we have a trading horizon of only a few hours (i.e.a day trader). Simply adjust your chart to your preferred time frame. It should also be noted that this moving average system should only be used as part of a trend trading system, as it can cause whipsaw in ranging markets. I.e. where a markets price heads in one direction, but then is followed quickly by a movement in the opposite direction.

The Double Moving Average Crossover.

Another kind of crossover is when we plot 2 moving averages on a chart – a shorter moving average and a longer one. In general longer day moving averages (50, 100, 200) are better indicators for longer-term momentum and short-term moving averages (5, 10, 20) indicate more immediate momentum moves. We can see the affect of shorter-term and longer-term indicators in the section below – Moving Average Sensitivity. 

This strategy highlights buy and sell positions when 2 differing moving averages cross over, again indicating a momentum change. These crossovers are popular with traders because they take the emotion out of trading decisions. When the shorter moving average crosses above the longer one we might place a buy order and when the longer moving average crosses above the shorter-term one we might place a sell order or go short. 

In our chart below we have a 5-day and 10-day moving average charted on a EURUSD daily chart. Buy signals occur when the 5-day crosses above the 10-day and sell signals arise when the 10-day crosses above the 5-day. Traders will use this info with other indicators to form their trading strategies. You can see the 2 areas of false signals - whipsaw. This is when the price moves in one direction then quickly changes in the opposite direction. Traders may have incurred losses here, but you can see 3 good runs of profit highlighted by the green arrows. Adding additional levels of moving average can reduce false signals.

EUR/USD - Double Moving Average Crossover

Trading The Double Moving Average Crossover.

So what period MA's should you use?  Again, it depends on your trading time frame.  A swing trader (in the market for 3 to 5 days) may want to use a 5 and 8 day MA combination, while an investor willing to hold shares for a few years may use a 100 and 200-day MA combo along with other indicators.  A simple MA crossover strategy may buy or sell on a crossover with a stop/loss placed either (i) above or below the closing high or low of the previous day (depending on whether the trade is long or short), or (ii) at tactical support and resistance levels using historical levels, Fibonacci or trend lines.  Risk/reward will also be thought of in any strategy (you don't want it too low - 2:1 or 3:1 is good).  This strategy will be used in a trending market.  We'll talk Risk/Reward, Fibonacci etc... in later modules

Triple Moving Average Crossover 

We can gauge the weight of a trend & determine changing momentum by charting additional levels of moving average. This can add another degree of robustness to our trading signals – The triple moving average can be measured with any moving average range combination depending on the time frame you want to look at. E.g. a 5, 10 and 20-day combination. For example, when the 5-day crosses above the other two this is our buy signal, or when the 5-day crosses below the other two we should sell. To further reduce the number of false signals, traders may also wait on the 10-day to cross the 20-day. This acts as an added confirmation to momentum changes, but may mean traders miss the momentum trade, or see it late.

The Triple Moving Average Crossover
 

In the chart below we have a 50, 100 and 200-day EMA. When the 50 crosses below the 100-day EMA this may trigger a sell signal if we're using a double MA crossover system. In hindsight this is a good trade as the price continues downwards for a long period. However, we're using a triple moving MA crossover here. If our system was to wait for the 50-day to cross both the 100 and 200-day EMA to set a trigger (blue arrow), even though the long-term trend was downwards, we would probably have been stopped out as price shot up prior to falling. This obviously depends on where our stop loss would have been.

If our system was to wait for the short term MA and the medium term MA to both cross the long term MA, thus a double confirmation of momentum change, then our entry point would have been triggered at the blue line.  A nice little down trend would have been caught prior to a ranging period.

Triple Moving Average Crossover

The Triple Crossover is one of the best indicators of trend momentum changes. However it is less responsive to initial trend changes than the single or double crossover methods – and that’s the traders dilemma.  A faster trade at the start of a trend with the likelihood of a false trade signal greatly increased, or a slower reaction missing out on some profits, but with added confirmation and fewer false signals. We can see this at work in the above chart and as we explained in the previous two paragraphs.  

Moving average Ribbons

Adding even more moving averages confirms the changing trend even more, but is less responsive to the initial change as we have to wait for the shortest-term moving average to cross the longest one. This is called The Moving Average Ribbon. As in the below chart of The Mini S&P, we place many moving averages on our chart to indicate a strong trend.  A trend is said to be strong when all the moving averages are pointing in the same direction.  You can see that the shorter term moving averages (in yellow) start to dip below the longer-term ones in red.  A trade when the shortest moving average crossed the 2nd shortest (at point 1) may have been profitable, however the ribbon sequence didn’t complete.  In the chart I've highlighted the completion of the ribbon sequence and confirmation of a strong trend, establishing good trading points – trend confirmation is stronger using ribbon MA's.

The shorter the time periods in the ribbon, the more sensitive the average is to price changes.  To determine long-term trend changes a ribbon between 50 and 200 is commonly used, sometimes in 10-day increments. As ever, more technical analysis is generally required prior to trading. Using Volume & Oscillators will help confirm changes in momentum.  Stop/loss positions can be set by a percentage system, trend lines or historical levels etc... and we can set a trailing stop to lock in profits.  Money management is key and we'll dedicate a whole module to this later.

Mini S&P - Moving Average Ribbon

Moving Average Sensitivity

As we discussed in the Double Moving Average Crossover section above, the time period of the moving averages determine the sensitivity of momentum changes. So, in general shorter-term moving averages are useful to gauge shorter-term price movements and vice-versa for longer-term moving averages. The shorter-term moving average crossovers will also indicate more buy and sell signals. We can see this clearly on the chart below of The Nikkei. Here we’ve plotted a 5, 10, 20-day EMA against a 50, 100, 200-day EMA and by using triple MA Crossover as an indicator we can see our buy signals and sell signals. A short-term trader would be looking at many signals, while a trader looking for a long-term trend would be confronted with only one buy signal. Both traders would be in winning positions, depending on the stop/loss situation and their individual trading strategy.  

Nikkei 225 - Moving Average and Sensitivity

To Sum Up

Moving averages are great for spotting trend, identifying areas of support and resistance, using as stop/loss positions, identifying changes in trend & price momentum and establishing trading trigger points.  Many trend following trading strategies will have moving averages at their heart.

We can set the indicators price action sensitivity. The sensitivity of the indicator to price action determines how quickly the trader enters the move and how accurate these trading signals are. If the indicator is set to low sensitivity then you generate less false signals, but you may see the move too late, or not see it at all. With high sensitivity you are more likely to catch the move into the trade, but you may generate false trading signals.  For instance a swing trader (trading with a horizon of 4 to 5 days) may set the MA's to 3 & 10 once they've drill down to an hourly chart from a daily chart. Reducing the parameters of the moving averages will increase the sensitivity and highlight more signals - good and bad.  Good charting software will allow the parameters to be changed. 

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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Moving averages (ii)

Moving Average Crossover – Price moving Across the Moving Average

The most basic type of crossover is when the price of The Market moves from one side of a moving average to another. When price closes below the moving average, this may suggest the start of a downtrend (within your trading horizon) and a trigger to sell may occur. When price closes above the moving average, this may suggest the start of a up trend (again, within your trading horizon) and a trigger to buy may occur. 

Your chosen time frame depends on your trading style and the system you employ. For instance, if you're a position trader where you plan to stay in a trade over a few months then you may execute trades from a daily chart using a 50-period moving average. In our Lennar Daily Chart example below we can see that when price crosses above the 50-day simple moving average a buy signal is produced. 

Simple Price Crossing Moving Average System

This is a simplistic view for now and further on in this notepad we'll discover how to utilise further T.A in your system as well as looking at setting targets for our trades.  However, a simple sell trigger may occur when price crosses back below the 50-day SMA sometime in the future (not shown in this example). 

In our above eg. we're looking at a daily chart (where each candle represents a days price action), but the same trigger will apply if we have a trading horizon of only a few hours (i.e.a day trader). Simply adjust your chart to your preferred time frame. It should also be noted that this moving average system should only be used as part of a trend trading system, as it can cause whipsaw in ranging markets. I.e. where a markets price heads in one direction, but then is followed quickly by a movement in the opposite direction.

The Double Moving Average Crossover.

Another kind of crossover is when we plot 2 moving averages on a chart – a shorter moving average and a longer one. In general longer day moving averages (50, 100, 200) are better indicators for longer-term momentum and short-term moving averages (5, 10, 20) indicate more immediate momentum moves. We can see the affect of shorter-term and longer-term indicators in the section below – Moving Average Sensitivity. 

This strategy highlights buy and sell positions when 2 differing moving averages cross over, again indicating a momentum change. These crossovers are popular with traders because they take the emotion out of trading decisions. When the shorter moving average crosses above the longer one we might place a buy order and when the longer moving average crosses above the shorter-term one we might place a sell order or go short. 

In our chart below we have a 5-day and 10-day moving average charted on a EURUSD daily chart. Buy signals occur when the 5-day crosses above the 10-day and sell signals arise when the 10-day crosses above the 5-day. Traders will use this info with other indicators to form their trading strategies. You can see the 2 areas of false signals - whipsaw. This is when the price moves in one direction then quickly changes in the opposite direction. Traders may have incurred losses here, but you can see 3 good runs of profit highlighted by the green arrows. Adding additional levels of moving average can reduce false signals.

EUR/USD - Double Moving Average Crossover

Trading The Double Moving Average Crossover.

So what period MA's should you use?  Again, it depends on your trading time frame.  A swing trader (in the market for 3 to 5 days) may want to use a 5 and 8 day MA combination, while an investor willing to hold shares for a few years may use a 100 and 200-day MA combo along with other indicators.  A simple MA crossover strategy may buy or sell on a crossover with a stop/loss placed either (i) above or below the closing high or low of the previous day (depending on whether the trade is long or short), or (ii) at tactical support and resistance levels using historical levels, Fibonacci or trend lines.  Risk/reward will also be thought of in any strategy (you don't want it too low - 2:1 or 3:1 is good).  This strategy will be used in a trending market.  We'll talk Risk/Reward, Fibonacci etc... in later modules

Triple Moving Average Crossover 

We can gauge the weight of a trend & determine changing momentum by charting additional levels of moving average. This can add another degree of robustness to our trading signals – The triple moving average can be measured with any moving average range combination depending on the time frame you want to look at. E.g. a 5, 10 and 20-day combination. For example, when the 5-day crosses above the other two this is our buy signal, or when the 5-day crosses below the other two we should sell. To further reduce the number of false signals, traders may also wait on the 10-day to cross the 20-day. This acts as an added confirmation to momentum changes, but may mean traders miss the momentum trade, or see it late.

The Triple Moving Average Crossover
 

In the chart below we have a 50, 100 and 200-day EMA. When the 50 crosses below the 100-day EMA this may trigger a sell signal if we're using a double MA crossover system. In hindsight this is a good trade as the price continues downwards for a long period. However, we're using a triple moving MA crossover here. If our system was to wait for the 50-day to cross both the 100 and 200-day EMA to set a trigger (blue arrow), even though the long-term trend was downwards, we would probably have been stopped out as price shot up prior to falling. This obviously depends on where our stop loss would have been.

If our system was to wait for the short term MA and the medium term MA to both cross the long term MA, thus a double confirmation of momentum change, then our entry point would have been triggered at the blue line.  A nice little down trend would have been caught prior to a ranging period.

Triple Moving Average Crossover

The Triple Crossover is one of the best indicators of trend momentum changes. However it is less responsive to initial trend changes than the single or double crossover methods – and that’s the traders dilemma.  A faster trade at the start of a trend with the likelihood of a false trade signal greatly increased, or a slower reaction missing out on some profits, but with added confirmation and fewer false signals. We can see this at work in the above chart and as we explained in the previous two paragraphs.  

Moving average Ribbons

Adding even more moving averages confirms the changing trend even more, but is less responsive to the initial change as we have to wait for the shortest-term moving average to cross the longest one. This is called The Moving Average Ribbon. As in the below chart of The Mini S&P, we place many moving averages on our chart to indicate a strong trend.  A trend is said to be strong when all the moving averages are pointing in the same direction.  You can see that the shorter term moving averages (in yellow) start to dip below the longer-term ones in red.  A trade when the shortest moving average crossed the 2nd shortest (at point 1) may have been profitable, however the ribbon sequence didn’t complete.  In the chart I've highlighted the completion of the ribbon sequence and confirmation of a strong trend, establishing good trading points – trend confirmation is stronger using ribbon MA's.

The shorter the time periods in the ribbon, the more sensitive the average is to price changes.  To determine long-term trend changes a ribbon between 50 and 200 is commonly used, sometimes in 10-day increments. As ever, more technical analysis is generally required prior to trading. Using Volume & Oscillators will help confirm changes in momentum.  Stop/loss positions can be set by a percentage system, trend lines or historical levels etc... and we can set a trailing stop to lock in profits.  Money management is key and we'll dedicate a whole module to this later.

Mini S&P - Moving Average Ribbon

Moving Average Sensitivity

As we discussed in the Double Moving Average Crossover section above, the time period of the moving averages determine the sensitivity of momentum changes. So, in general shorter-term moving averages are useful to gauge shorter-term price movements and vice-versa for longer-term moving averages. The shorter-term moving average crossovers will also indicate more buy and sell signals. We can see this clearly on the chart below of The Nikkei. Here we’ve plotted a 5, 10, 20-day EMA against a 50, 100, 200-day EMA and by using triple MA Crossover as an indicator we can see our buy signals and sell signals. A short-term trader would be looking at many signals, while a trader looking for a long-term trend would be confronted with only one buy signal. Both traders would be in winning positions, depending on the stop/loss situation and their individual trading strategy.  

Nikkei 225 - Moving Average and Sensitivity

To Sum Up

Moving averages are great for spotting trend, identifying areas of support and resistance, using as stop/loss positions, identifying changes in trend & price momentum and establishing trading trigger points.  Many trend following trading strategies will have moving averages at their heart.

We can set the indicators price action sensitivity. The sensitivity of the indicator to price action determines how quickly the trader enters the move and how accurate these trading signals are. If the indicator is set to low sensitivity then you generate less false signals, but you may see the move too late, or not see it at all. With high sensitivity you are more likely to catch the move into the trade, but you may generate false trading signals.  For instance a swing trader (trading with a horizon of 4 to 5 days) may set the MA's to 3 & 10 once they've drill down to an hourly chart from a daily chart. Reducing the parameters of the moving averages will increase the sensitivity and highlight more signals - good and bad.  Good charting software will allow the parameters to be changed. 

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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