- February 23, 2021
- Posted by: Trading
- Category: News
Strategies based on moving averages do work, but there are a few things to keep in mind.
How they work
The moving average is probably the most fundamental indicator used by technical analysts. The simplest of which is the simple moving average (SMA or just MA for short), which essentially averages out the closing prices at your chosen time frame and displays them as a line over the current price action. So, if you’re viewing a 1-day chart of the EURUSD pair and you apply a 10-period moving average, you get a line that represents the average of the past 10 closing daily prices plotted over the current price. What this does, is smooth out the jagged peaks and troughs so as to give you a clearer idea of the general trend, stripped of all that short term “noise.” Exponential moving averages (EMAs) do much the same thing, only in a slightly more complicated way. By giving more emphasis, or “weight,” to more recent closing prices, EMAs react quicker to sudden moves and, therefore, follow the current price more closely than SMAs.
As you can see from the above chart, what the moving average essentially does is to give the trader a visual representation of where the current price finds itself in relation to an average of closing prices (10 daily closes in our EURUSD example). Some popular moving averages include 10, 20, 50, 100 and 200-period moving averages. The greater the number of periods factored into the calculation, the smoother the line will be, the slower it will react to changes in price, and the longer it will trend.
A simple strategy
The simplest type of moving average strategy is to buy when the price crosses the moving average from below to above and to sell when it crosses it from above to below. Some strategies specify that you have to get a close above or below said moving average for the buy or sell signal to be valid. This may sound way too simple to yield any real benefits, but in certain markets, it can be a highly effective indicator.
For example, as you can see below, Bitcoin’s 20-week moving average has historically provided highly effective buy and sell signals when used in this manner. In a strong uptrend, the price will test the moving average as support when the price consolidates. In a strong downtrend, it will test the moving average as resistance when it comes back up. Longer-term moving averages can also be used to signal changes in trend. For instance, when a bull market fails to find support above a moving average or when a bear market breaks resistance above it (as it does in the chart below in 2019).
A more complex moving average strategy is to plot two moving averages, one short and one long (say, a 20-period and a 50-period MA). As we have explained above, the shorter moving average will react quicker to current changes in price because it takes fewer closing prices into account in its calculation. The longer moving average will react slower because it’s averaging more closing prices from further back, which means that any current closing prices will have less of an effect on the overall average. When using multiple moving averages, what technical analysts look for are called crossovers. Instead of looking for the price action to close above or below a single moving average line, they instead look at the interaction between the two moving averages they have plotted. So, when the 20-period MA crosses above the 50-period MA, it is considered a bullish cross, and when it crosses below it, it’s considered a bearish cross. Below we have three such crosses on a gold chart, two bullish and one bearish.
There are several major issues with relying exclusively on strategies that are structured around moving averages. Firstly, moving average strategies are incredibly vulnerable to fakeouts. Sometimes the price can break convincingly above or below a moving average, providing buy or sell signals, only to reverse again and continue trading in the opposite direction. You can clearly see this in our first screenshot. Between March and May, EURUSD broke above the moving average a total of three times only to head back down through it. It was only on the fourth break that a bullish move was successfully initiated.
Secondly, moving averages are most useful when the market you’re trading is trending strongly in a single direction. The Bitcoin chart above in our second screenshot is a clear indication of this. The 20-week strategy has historically worked so well because, in its short history, Bitcoin has experienced several strong and clearly defined bull and bear markets. On the other hand, when the price action is choppy rather than strongly trending, moving averages will provide you with many false buy and sell signals that don’t yield any real gains and generally have the effect of churning your account. Again, you can see this in March-May of the first screenshot. If you were to buy EURUSD at the crosses above and sell at the crosses below the moving average line, you would have bought and sold three times apiece, all of which would have been unprofitable and missed the bulk of those moves up and down. This brings us to the next point.
Thirdly, moving averages necessarily lag behind the price action; after all, they are entirely based on averaging-out previous prices. This lag can be even more pronounced when you employ crossover strategies because these rely on the position of one moving average in relation to another and these move slower than the actual price. In the third screenshot you can see that by the time the 20-MA crosses below the 50-MA, the price has already recovered from that pronounced sell-off and is about to initiate a new move up.
Strategies based on moving averages do work, but there are a few things to keep in mind. Based entirely on the past, they have no ability to predict future movements. What they do is either fit well or not well over an existing trend and it’s the trader’s job to correctly analyse the asset, to identify the possible trend at a given time frame, and to see which moving average (or combination of them) seems to fit with the price action. Find the fundamental reason for your market’s direction first and only then, look for your technical strategy.
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