Using Moving Averages to Identify a Trend
This is the most basic way traders will use MA’s. In our chart example below we have a daily Forex chart of USD-JPY in which we have a 20-day EMA overlay. When the price moves above or is above the moving average then this area is generally regarded as a buying zone and vice versa. Many traders will only consider holding a long position when the price is trading above the MA. I've highlighted a choppy period where traders may have placed short trades when the price drops below the MA. Any “short trade” may have been burned here, as the price went back above the MA due to volatility. Eventually the price did trend down, but not before any potential short trade losses.
Using Moving Averages to Identify a Trend
This scenario is a simple one and using the moving average isn’t one we should use exclusively to identify buy/sell opportunities, but one in combination with chart patterns, price action, other indicators and tools. One of the main advantages of the above scenario is the ability to identify trend and that's all we're trying to show here. Also, look how the 20-day MA acts as support and resistance for this market throughout this period - Moving Averages make good support and resistance levels. For more on support and resistance and their psychological impact visit Module 6. The Psychology of Support and Resistance.
The period of moving average used all depends on your trading time frame. A day trader may start on a daily chart with a 20, 50, 100-day MA to gauge primary trend, then drill into a 5 minute chart using a 10-period EMA to pick entry and exit points. His/Her trades may only last minutes or hours, while a longer term traders may have a time horizon of weeks and months. Different systems will require different MA parameters, but whatever type of trading you're strategy leads to, the technical analysis is similar. Hopefully by the end of the course, you'll be able to identify what kind of trading will suit your lifestyle.
Using Moving Averages to Measure Momentum
MA’s can be used not only to identify the direction of the trend, but also to measure the trends change in momentum (the price’s rate of acceleration or deceleration). The best method to determine the price's change in momentum is to place 3 moving averages upon the market chart. A smaller period MA will measure short-term momentum and a larger period MA will measure long-term momentum. A divergence between different MA's measures price momentum increases and decreases. Let's explain it further below.
On the below daily chart of Ford Motor Co we've placed a 50 (blue), 100 (red) and 200-period MA (yellow) to look at short, medium and long-term momentum. We can see that the short-term MA’s move above the long-term MA’s at around $12 to $12.4. They then diverge from one another indicating a strong upward increasing momentum or acceleration of the price. Incidentally, the opposite will also the case when the trend is downwards - short-term MA’s are located below longer term MA’s and diverge to indicate increasing downward price momentum. Also note that contracting MA's indicate that momentum is decreasing and price may reverse.
Moving Averages as Support and Resistance & setting Stop/Loss positions
Moving averages can often provide price support and resistance of an asset, particularly the more popular moving averages – The 10, 20, 50, 100 and 200-period MA’s. These are the MA’s that most traders will look at, so offer good psychological levels of support and resistance – especially the 200-day MA. In an up trend the MA can act as support and in a down trend may act as resistance. We've already seen how this works in the above chart "Using Moving Averages to Identify a Trend". This important concept combined with other TA is a great tool for managing risk and is key to a successful trading strategy, as we can utilise support and resistance to help execute trades as well as setting our risk management rules (in the form of stop/loss orders)
It’s important to notice, when looking at support and resistance levels, that the price sometimes overshoots the MA’s as markets are driven by emotions as well as psychology. So think of the MA’s as bands rather than definite hard lines. The Moving Average Envelope explains this more. Here, traders will plot 2 bands around a moving average – e.g. 5% +/- around the moving average. Traders then monitor these bands to see if they act as strong support or resistance. If the price crosses the moving average band, then momentum may change.
In our below example of The NYSE composite Index the 200-day MA is offering support at various points from July 2005 to late 2007. As the more popular moving averages offer psychological support and resistance levels, many traders anticipate a bounce from this moving average. They’ll trade accordingly, maybe using the MA as buying opportunities, or placing a trailing stop/loss just under the moving average support level to limit losses if price momentum changes. You can see the burn areas where the price actually falls below the MA. This is why you may want to think of MA's as bands, if you don't want to get stopped out all the time. When the price does eventually break below the MA in Jan '08, momentum had shifted and now the 200-day MA becomes resistance.
NYSE - Moving Average as Support and Resistance Example and Stop/Loss
It is not uncommon to see the moving average become resistance, preventing investors pushing above it. You can see this clearly happen in mid may 2008 where the 200-day moving average becomes our resistance. This confirmation resistance bounce may have allowed traders to go short on the trade with a stop/loss situated just above the moving average. Shorting at 9490 just after the bounce from resistance with a stop/loss just above that level would have made a hefty profit, as this was the time of the 2008 financial crisis. Hindsight is always 20/20…