The Moving Average Strategy Guide For Trading in 2020
This comprehensive article on Moving Averages and the Moving Average Indicator will provide traders with a detailed breakdown of what moving averages are, why traders should apply long-term moving averages and how to use the moving average indicator in MetaTrader 5 (MT5). To round off the article, we will share some useful moving average trading strategies to use in 2020!
Of all the many trading adages, 'the trend is your friend' is perhaps the most common. As well worn as this phrase may be, it does contain an element of truth. Many profitable trading strategies revolve around entering the market when there is an above average chance of a new trend forming. When a trend does occur, the key is to hold on for as long as the trend persists.
This article is going to discuss why the Moving Average Indicator is an essential trading indicator that can be used as a means of identifying trends. But this is not its only use. The indicator has other wider applications for helping sift through the noise of price fluctuations. The Moving Average Indicator may also prove useful in developing your own trading strategy.
What Is a Moving Average?
You can calculate a moving average over any data set that changes with time, but in technical analysis, its most common usage is with price. A moving average (MA) is a continuously calculated value of the mean average of the price over a specified time period. The moving part of the name is there because we calculate a new value as each time frame advances, so that the value of our average adjusts with changes in the price.
So, for example, we might use a 30-day moving average. The value is the mean average of the price over the previous 30 days. In other words, we add up each of those 30 closing prices and then divide by 30. This value is calculated each day, discarding the oldest value in the data set, in favour of the most recently occurring day. The effect of a moving average is to smooth out price fluctuations. This helps us to look beyond transitory or insignificant blips in price, and instead see the longer-term tendency of the market.
Economists and analysts have been using moving averages in their studies long before the advent and availability of personal computers arrived to aid their calculations. Thankfully, these days, calculating moving averages over pretty much any desired timeframe has never been easier, requiring simply the click of a button.
Long-Term Moving Averages
Identifying the Long-Term Trend
Price charts can sometimes be confusing for traders. Large corrections could make traders lose track of the trends and the overall picture. They may get distracted by the many ups and downs that price action can create. Long-term Moving Averages help traders keep their focus, quickly allowing them to understand whether a trend is present. The MA also identifies the direction of the trend. Here is the main summary of using moving averages for the trend:
- Trend is present → price action is far away from the long-term Moving Average (MA)
- Long-term MA has bearish angle → downtrend
- Long-term MA has bullish angle → uptrend
- Trend is retracing → price action is retracing back to the long-term MA
- No trend is present → price action is oscillating around the long-term MA
The long-term MA keeps traders on the right side of the financial markets. It helps traders to avoid risky reversal setups, and allows them to enter setups that are keeping with the trends.
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPJPY H1 Chart. Date Range: 16 June 2020 - 14 July 2020. Accessed: 17 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Key Decision Zone: Bounce or Break Spot
Identifying the trend is not the only advantage of using long-term moving averages. Price tends to respect and stop at the long-term MA levels. The MA levels are key and critical decision zones for either a trend continuation or a larger reversal:
- If the price breaks the long-term MA, a reversal is likely
- If the price bounces slowly at the long-term MA, the price can break both ways
- If the price bounces strongly at the long-term MA, a trend continuation is likely
The reaction of price at the long-term moving average is certainly valuable information to take into consideration. Of course, it is best to take other factors into consideration as well, such as tops and bottoms, Fibonacci levels, and other indicators to find a confluence of support and resistance.
The more confluence, the more important a decision zone becomes. This in turn means that the breakout or bounce will have more value, and can be considered more important. Traders can trade these breakouts and bounces by, for instance, waiting for Japanese candlestick patterns to indicate whether a bounce or breakout is occurring. Traders can then judge whether the candle pattern is interesting for a trade setup or not.
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on AUDUSD H4 Chart. Date Range: 23 January 2020 - 5 June 2020. Accessed: 5 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Which Are the Best Moving Average Levels?
The Exponential Moving Average (EMA) gives more weight to more recent price values. The amount by which this weighting decreases for each successively older price value is exponential, hence the name. Whereas, the Simple Moving Average (SMA) gives equal weighting to all price values incorporated in the time frame.
Popular MA settings are often around levels such as 100, 150 and the 200 period. Some traders also use Fibonacci sequence levels for MA's such as 89, 144, or the 233 period.
That being said, short-term and medium-term moving averages remain important too, but for different purposes. The short-term MAs are best used for determining momentum, and support and resistance zones. The medium term MA's are useful for assessing retracement and correction targets.
Short-term moving averages are anything between 0 and 20 MA, whereas medium-term MAs are usually between 20 and 100 MA. These settings can, of course, vary from trader to trader, but this is a general rule of thumb. Many traders in fact add all three types of moving averages to their chart:
- One moving average around 5-20
- One moving average around 20-100
- One moving average that is 100+
The advantage of applying all three moving averages to the chart is that traders are able to get a fuller view on various tendencies of the price. However, this article aims to primarily emphasise the importance of long-term moving averages for analysing charts. Of course, make sure to use these ideas explicitly via financial instruments, but only once you have completed your own proper analysis first. This is a supportive method of analysing the charts. Always test any moving average strategy first, through a demo account, before applying them to a live account.
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MA for Trend and Momentum
The main value of using moving averages in Forex is the MA's ability to quickly determine the presence, and the direction of trend and momentum. Here are three statements to help you distinguish between trend and momentum:
- An overall trend occurs if the price moves away from the long-term MA: higher (uptrend) or lower (downtrend)
- A short-term trend is visible if the price moves away from the medium MA: higher (bullish) or lower (bearish)
- Momentum is visible if the price moves away from a short-term MA: higher (bullish) or lower (bearish)
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on USDJPY H1 Chart. Date Range: 26 June 2020 - 6 July 2020. Accessed: 6 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
The best trending movements are when the price, the short-term trend, and the overall trend are aligned in one direction. For an uptrend this means that the price is above the short-term MA, and the short-term MA is above the trend MA.
For a downtrend this means that the price is below the short-term MA, and the short-term MA is below the trend MA. The chart lacks a trend or momentum, if the price is moving around the MA (i.e. called a correction) or if it is going back to the MA's (this is called a retracement or a pullback).
Corrections can unfold in two ways: passively or aggressively. A passive correction is when the price goes sideways, and the moving averages catch up with the price. An aggressive retracement is when the price moves impulsively (quickly), back towards the moving average(s).
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on USDJPY M15 Chart. Date Range: 16 July 2020 - 17 July 2020. Accessed: 6 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
The Hidden MA Gem
MAs are valuable as support or resistance, when the market is trending and moving impulsively. As the market gains momentum, the price will still make smaller pullbacks along the way. These pullbacks typically retrace back to either a shallow MA like the 8 MA, or a short-term MA, like the 20-40 MAs, before the momentum continues.
In these cases, the MA's turn into a solid support or resistance level, which often caps the light pullback from a further counter-trend movement. One approach to visualise support or resistance is by applying the same MA in three different ways, such as:
- A 21 MA close
- A 21 MA low
- A 21 MA high
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPJPY H4 Chart. Date Range: 29 May 2020 - 6 August 2020. Accessed: 6 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Together, these three MAs create a band or zone of support and resistance. The biggest advantage of having three MAs act as support and resistance, rather than just one, is that the market tends to respect a rough range, rather than a single support or resistance point, so a price zone always has more value than a single price point.
It is important to note that the MA's will not act as support or resistance if the market is in a large consolidation (i.e. a lack of trend). When adding an MA, it is recommended to complete some backtesting using an easy-to-use trading platform, such as the MT5 Supreme Edition plugin.
Moving Averages For Divergence and Reversal Targets
Eventually the trend will end, and a phase of either consolidation or reversal will start. The chance of pullback increases substantially once the trend loses its momentum, which creates a divergence between the highs (in uptrend) or the lows (in downtrend). Divergence is a strong indication of either a pending retracement within the trend, or an end of the trend and a subsequent reversal.
Divergence is when an asset's price is moving in the opposite direction of a technical indicator, it can be identified using an Oscillator (below we use the Relative Strength Index or RSI). If the price is reaching new highs, but the oscillator is achieving lower highs, then positive divergence is taking place. If the price is reaching new lows, but the oscillator is achieving higher lows, negative divergence is taking place.
Whether the price shows a shallow pullback or a full reversal depends on the strength of the support and resistance nearby, as well as the time frame where the divergence is visible. The MA can also be used in various different ways, for instance, when the price starts its counter-trend move including as: an entry for further trend continuation, or a target for a reversal trade.
Here are some important concepts to use as a rule of thumb when applying a moving average RSI strategy to Forex trading:
- A lack of divergence could see the price retrace to and bounce at a shallow 8 MA
- A single divergence on a one-hour chart or lower will mostly create a slight retracement, which means that the price could pull back to and bounce at the 21 MA
- A single divergence on a four-hour chart or higher will mostly create a sturdy retracement, which indicates a good chance of price retracing back to, and bouncing at the 144 MA
- A double divergence should initiate a stronger pullback, which means that the price pulls back to a 144 MA
- Divergences on multiple time frames will increase the chance of a reversal, which means that the price could pull the 21 MA to the opposite side of the 144 MA
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPUSD H1 Chart. Date Range: 16 June 2020 - 24 June 2020. Accessed: 13 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
The targets featured in the image above are of course rough indications. It is important to realise that the targets could be missed before the trend continues, and to analyse each financial instrument on its own merit and within its own context.
Using the Moving Average Indicator in MetaTrader 5
As it is one of the more common technical indicators, it is no surprise that we don't need to download a moving average indicator when using MetaTrader 5. The moving average comes as one of the standard set of tools with the trading platform. You'll find the MT5 moving average indicator inside the 'Trend' folder of the 'Indicators' in MetaTrader's 'Navigator', as shown in the image below:
Source: Admiral Markets MetaTrader 5 - Selecting the moving average indicator
The image above also shows the dialogue box that opens when you click on the MA indicator. The three main variables to choose are:
- Period — the time frame over which the average is calculated (default value = 100)
- MA method — how the average is calculated (the default method is 'Simple', which is the equally weighted mean of the preceding number of periods)
- Apply to — the price value that you are averaging (default value is the closing price of each period, but there are several other options, including open, low, and high)
When it comes to the method, there are several complex types available beyond the SMA. The most common of these is the EMA. The image below displays the MT5 SMA indicator once it has been added to an hourly GBP/USD chart:
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPUSD H1 Chart. Date Range: 6 August 2020 - 13 August 2020. Accessed: 17 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
The moving average applied in the chart above was a 30-period SMA for the close. For each point plotted by the MA indicator for a specific hour, the value is calculated as the mean average of the GBP/USD closing price for each hour, going back over the previous 30 hours. Notice how the moving average smooths out short-term fluctuations in the price. You can think of it as a guide, helping you to see the overall picture of what the market is doing.
Trading With the Moving Average In MT5
The MA is usually the first indicator that traders attempt to trade with. Yet it's also generally the first indicator that is removed from their chart. Why is that? One of the main reasons is that traders see that the moving average is lagging. This is true, but it is crucial to note that moving averages offer numerous advantages for traders using technical analysis, advantages that clearly outweigh this negative. So removing moving averages from your analysis is a mistake.
The extra value of trading with a moving average strategy is not based on overly simplistic and unprofitable approaches, like late crossover entries, but is instead rooted in its ability to identify trend and momentum, to act as support and resistance, and to clarify divergence.
The most basic strategy is to simply compare the moving average to the current price. From a trend-following perspective, if the price moves above the moving average, it is a bullish indication. If the price falls below the moving average, it is bearish. When a new trend forms, we will always see the price breaking out from the moving average in these ways. This really is quite a rudimentary method, though.
You should be mindful that the price will sometimes cross over the moving average without a trend subsequently forming. We can also come up with other strategies by adding more than one Forex moving average indicator to our price chart. Let's start by looking at a moving average strategy that utilises two moving averages.
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Moving Average Trading Strategies
The Crossover Moving Average Strategy
This is a simple moving average strategy that provides you with a signal to trade when a faster moving average crosses over a slower one. Take a look at the hourly GBP/USD chart below. A 30-period Forex moving average has been added, which appears as a thin, dotted red line. A slower 100-period moving average has also been added, which is the thicker green line:
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPUSD H1 Chart. Date Range: 20 July 2020 - 27 July 2020. Accessed: 13 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
The rules of the strategy are simple — when the faster MA crosses above the slower one, you buy. When it crosses below, you sell. As you can see, at 18:00 on 20 July, the faster MA crossed above the slower MA. This was our signal to buy. Notice how in the example above the price continued to trend higher after we received the buy signal. However, it is important to note that this will not always be the case.
This trading strategy always leaves you with a position in the market, either long or short. The signal to close your position would be when the faster MA crosses back below the slower one. At this point you would square and reverse, going short in the market. So what can we do if we don't always want to have a position in the market? We can use a slightly more complex version of the strategy, that uses three moving averages instead of two. This is known as the triple moving average strategy.
The Triple Moving Average Trading Strategy
As the name suggests, this moving average strategy uses three MAs: one fast, one medium, and one slow. The trading signals are generated by the fastest moving average crossing over the medium-length average, just as with the dual strategy. There is an additional rule to consider however. This rule has the slowest moving average to act as a trend filter. That is to say, that you can only place a trade if the two faster MAs are the right side of the filter.
To go long, both need to be higher. To take a short position, both need to to be lower. The daily GBP/JPY chart below shows three moving averages added for this strategy. The red line is a 150-day moving average. The green line is a 250-day moving average. The blue line is a 350-day moving average — this is our filter line.
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPJPY Daily Chart. Date Range: 8 August 2019 - 13 August 2020. Accessed: 13 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Note that there are two points on the chart where the fast red line crosses the green line. The first time is a cross above, indicating a buy signal. But because our signal lines are beneath the filter, we do not trade at this point. However on the second time, when the fast red MA crosses beneath the medium-length green one, we go short, because both lines are the correct side of the blue filter line for a sell position.
Moving Average Ribbon Strategies
A moving average ribbon is a collection of MAs (usually between 6 and 16) with a variety of time periods on the same chart. The result of these multiple MAs, produces a ribbon like effect, hence the name. The MAs vary in length from short-term to long-term and the resulting ribbon effect provides an indication of both the trend direction and strength.
When the MAs are parallel and evenly spaced, this means that the current trend is strong. An expansion between ribbons can indicate the possible end of the current trend and the contraction of the ribbons indicate the beginning of a new trend.
As with previous strategies, buy and sell signals are indicated by crossovers. However, due to the number of MAs and, therefore, crossovers involved, the trader must decide for themselves how many crossovers indicate a suitable trading signal for their moving average ribbon trading strategy.
On the chart below there are 11 EMAs (10,20,30,40,50,60,70,80,90,100,150).
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on EURGBP Daily Chart. Date Range: 19 August 2019 - 13 August 2020. Accessed: 13 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Moving Average With Keltner Channel Strategy
Trading using the MA indicator is based on the assumption that future values will tend to follow the trend. Historical data is an imperfect guide to predicting the future unknown, however, it is one of the few tools we have available.
Moving averages provide a simple and effective demonstration of the average value of an asset over an observed period of time.
Instead of solely relying on MAs, some traders may choose to use moving average trading strategies which use the MA as a trend filter and enlist the use of a separate indicator for their trading signals.
An example of this would be trading using MAs and the Admiral Keltner Channel indicator.
In the below chart, we have a 20-period MA (red), a 50-period MA (green) and the Admiral Keltner with default settings.
Buy Signal: When the price breaks above the Keltner Channel
Sell Signal: When the price breaks below the Keltner Channel
The trader only enters the market when the above signals coincide with the direction of an overall major trend.
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on EURUSD H1 Chart. Date Range: 27 July 2020 - 10 August 2020. Accessed: 13 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Other Indicators That Incorporate the Moving Average
It is a testament to the versatility of moving averages that the technique is often incorporated as a part of more complex indicators and trading methods. A well-known example of this is the method of Bollinger Bands. Bollinger bands utilise a moving average envelope - whereby traders plot lines a certain distance above and below a moving average. These lines are known as bands or envelopes.
In the case of Bollinger bands, the lines are a volatility envelope. They are placed a certain number of standard deviations away from the moving average, which means that the bands widen or narrow according to the volatility of the market. Bollinger bands trading, therefore, is a type of moving average envelope trading strategy that takes into account the volatility of price movements.
We said earlier that simply comparing price to the moving average may provide false signals - tricky times when the price crossing the MA does not result in a trend. These false signals may be exacerbated by highly volatile markets. Using a volatility envelope can, therefore, be an effective way to mitigate this problem to some degree.
You can also apply the MA indicator on top of another indicator, rather than applying it solely to price. You might want to do this as a smoothing technique, if you feel the results of an indicator are so choppy that they make an underlying pattern unclear.
What Is the Best Trading Strategy?
So which is the best moving average strategy to trade with?
There's no one-size-fits all answer to this, because the most suitable trading strategy will depend on the preferences of the individual trader. One way to help you decide what works best for you is to backtest your strategy. The trading simulator that comes with the MetaTrader 5 Supreme Edition plugin is a great way to manually test different strategies.
It's a similar story when it comes to picking a suitable time frame for your averaging. If you are dealing on shorter time frames, you will need to be dealing with a suitably fast-moving indicator. So, if you are trading with an intraday moving average strategy, perhaps it makes sense for you to use a 30-period moving average on a 15-minute chart. If you are a long-term trend follower, you may find that something as long as a 350-day moving average is more appropriate. Someone looking to use a swing trading moving average strategy may use a time frame somewhere in between the two.
A useful way to decide which settings are best for your strategy is to experiment with a demo trading account. This will allow you to fine-tune your system without taking on unnecessary risk while you are still operating in trial-and-error mode.
Moving averages have many applications in trading. The beauty of the indicator is that you can make it as simple or as complicated as you need. At the simpler end of the spectrum, the indicator can help to smooth out fluctuations within a choppy market. This makes it easier to see what is happening, without the noise of volatility. Another basic use is as a rudimentary yardstick of the trend of the market over a given timeframe. A rising MA suggests an upward trend, and a falling MA suggests a downtrend, as we have seen.
Of course, you can choose to increase the complexity substantially from there, with weighted-moving averages and different cross-over strategies, incorporating multiple moving averages. We've covered just a couple of types of such crossover strategies here, but there is tremendous scope for further modifications. Bear in mind, though, that an increased level of complexity does not necessarily translate to increased success. Sometimes keeping it simple can be more effective, and is a very sensible way to start out.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.