What is the most common technical indicator? (Hint: Even fundamental analysts place this indicator on their charts.)
The moving average is the most common technical indicator. Why?
It is simple. It is versatile. It adds value, if you know its limitations.
In this trading guide, you will learn how to use this simple indicator to increase your profits.
Types of Moving Averages
While there are dozens of flavors of moving averages, there are just three basic types:
- Simple – A simple average of the past N prices. Just add the prices and divide by N.
- Exponential – An average of the past N prices with greater weight for recent prices. The weighting is exponential.
- Weighted – An average of the past N prices with a linear weighting.
Moving Average and Price Action
The first step to trading with a technical indicator is to see how it interacts with price.
To keep things simple, I am using a 20-period simple moving average here. You can also apply the same trading concepts with other types of moving average.
The basic function of a moving average is to smooth trends. You can just look at its direction for a quick trend assessment.
- Pointing up – Bull trend
- Pointing down – Bear trend
But things aren’t always that simple. To make sure that you are not trapped into the end of a trend, look at price action as well.
When price aligns with the moving average, the market is trending. When they oppose each other, the market is slowing down and might be reversing/retracing.
#2: Degree of Slope
A flat moving average hints at a sideways market.
A steep line results from movement on one side of the moving average. It indicates market strength and at times, price exhaustion.
Here, I am referring to the distance between the moving average and price.
In a sideways market, price tangles with the moving average. The is little or no gap between price and the moving average.
In a healthy bull trend, price stays a fair distance above the moving average. (Stays below in bear trends.)
In an overextended trend, you find exceptional distance between price and the average.
#4: Support & Resistance
A moving average acts as support and resistance.
Look for price bars that overlap with it. Watch out for the way price interacts with it. If it slows down as it tests the moving average, it is more likely to find support or resistance.
You can use the price behaviors above for finding the market trend, or for timing. Practice with different look-back periods. Higher settings work well for observing trends, and lower periods are good for timing.
Note that a moving average lags and responds to price action. This is why you must analyze it together with price action. This is the best way to place your analysis in context.
After practicing, you will find that trading with just a moving average is viable.
Moving Average and Other Technical Indicators
#1: Signal Line (Nesting)
The moving average is a part of many technical indicators. In trading oscillators like the RSI, MACD, and Stochastic, you find signal lines. These signal lines are in fact moving averages of the actual indicator values.
Signal lines are the result of nesting indicators. Nesting refers to using the output of one indicator as the input for another. I’ve used it in the OBV trading strategy, by using a moving average of OBV values.
#2: Multiple Moving Averages
In search of confirmation, same traders use multiple moving averages.
When multiple moving averages move in the same direction, it confirms a trend. When one crosses over another, it signals a possible trade entry.
The example below shows a trading system with three moving averages. (20, 50, 200-period)
#3: Price Bands and Envelopes
As mentioned, the distance between price and the moving average shows the market’s momentum.
Price envelopes are useful for quantifying the distance between price and the moving average. They perform well in sideways market by offering credible support and resistance.
The best known example is the Bollinger Bands. It consists of two standard deviation lines surrounding a moving average.
#4: Exotic Moving Averages
Lag is the major problem of a moving average. As more engineers become traders, there are more variants for reducing this lag.
I’ll leave you to choose your favorite one.
The only takeaway here is that none of these exotic options is the Holy Grail. They have their pros and cons. Do not use them without understanding how they differ from a simple moving average.
Let the Moving Average Guide You
The moving average is especially useful for traders who are new to analyzing price action.
However, using moving averages without thinking of the larger picture is not profitable. It clarifies price action but does not replace it.
A last word of caution: Let moving averages guide you, but do not let it control you.