We’ve already briefly looked at moving averages on this blog and the basic uses for them. They essentially give us a great indication of the overall direction of the market and smooth out the extreme peaks and troughs to give us a more balanced view of what’s going on. They’re an extremely popular type of indicator and a large percentage of trading strategies use them in some shape or form.
You may be thinking that trend definition is all they’re useful for but there’s actually another major use for moving averages that many beginners don’t realise and it can actually be the most powerful way to use them.
Before I describe it we need to back up a second and have a look at how the markets actually move. About 70% of the time the markets are fairly flat and range-bound and the rest of the time they’re trending up or down and those trending periods are generally when we can make the most money as traders. One of the key factors that we need to understand about a trend though is that they don’t simply move solidly in one direction but rather they move up or down in waves. As an example if we have a long up-trend, the market will generally make a series of peaks and troughs getting slightly higher each time.
Unfortunately this means trading isn’t quite as simple as buying whenever there’s an uptrend and selling whenever there’s a downtrend because if you do that there’s quite a big chance that you will buy at the peak of one of the waves and the market will turn against your position. That’s one of the dangers of the common phrase “the trend is your friend” that beginners often live by. The trend is only your friend if you understand how it works and find a way to take advantage of it.
So how can we use moving averages to take advantage of these waves in the trend?
If you apply certain specific types of moving averages to your charts they can actually act as floating support and resistance levels and can therefore give you an indication of when a pullback in a wave is likely to turn and continue in the direction of the trend.
Some examples of the strongest MA’s out there are the 200sma, the 62ema and the 21ema. For trend trading the 21ema is potentially the best one and can give you great trading set-ups over and over again. Next time you’re looking at a chart try applying a 21ema and look what happens during a strong trend. Chances are the market will repeatedly pullback to the moving average and then bounce away and continue in the direction of the main trend. If you combine this knowledge with a good reversal indicator like candlestick patterns you can build an extremely strong trading strategy that works in just about any market.
We will begin to look at trend trading using technical indicators in more detail in the future but for now moving averages give you a great starting point.