Introduction
Markets change state due to the arrival of news and you want an indicator thats capable of responding promptly to that change. The moving average is a dynamic way to measure or determine trend. Moving averages come in many different flavours and MT4 has built-in indicators to place a moving average of price on your charts: simple, exponential, smoothed and linear weighted.
Moving averages typically have 3 parameters - type, period and price:
Type: simple moving average, exponential moving average,smoothed moving average and so on;
Period: the is the time period over which the moving average (MA) is calculated. Fast or short MAs use smaller number of time periods and slow or long MAs have longer time periods. Short MAs are used to identify short term trends and long MAs identify longer term trends.
Price: this is the price value used to calculate the moving average. It can be the high, low, close or open price.
Moving average indicators can help you identify different types of signals.
1. Trend
The most common signal is the trend. An increasing MA will point towards an overall price increase, while a decreasing MA will recognise a decrease in the overall price level. When you want to identify a long-term trend, apply a longer time-frame such as 200 days. If an increase in the moving average is evident, then you have successfully determined an upward trend.
2. Crossover
You can also use two moving averages to identify crossover trading opportunities. Traders do this by combining short-term MA with a medium-term or long-term moving average. Setting up two moving average indicators, short-term and long-term moving average can be referred to as price crossovers. The general rules for crossover signals are:
When you see that the short-term moving average crosses over the long-term moving average then it means a bullish signal (bullish crossover) also named a “golden cross”
If the short-term moving average crosses below the long-term moving average, then it gives a bearish signal or dead cross
Let’s look at the graph below where the 20-day moving average and 50-day moving average are plotted:
At the upper left side of the graph, the 20-day moving average line crosses below the 50-day line in a downward direction. The point is signalling a bearish movement. On the other hand, a gold cross is identified on the graph on the right side when the shorter time-frame moving average crosses over the 50-day moving average, signalling a bullish movement.
The downside is that when a stable long-term trend is not identified, the crossover signals may be inadequate because of lagging in the moving averages. Be aware that in a volatile market, you can be exposed to a whipsaw (sudden reverse movements in prices) when using the crossover signals. This is especially important for short term traders as they are more exposed to volatility compared to long-term traders.
3. Support and Resistance
You can also use the moving average line to detect potential dynamic support and resistance levels of an asset price by looking to identify a spot where the current price meets or touches with the line. When it comes to using the moving average to identify support and resistance levels, traders read the signals as follows:
If the price intersects the moving average line from above, then the indicator signals potential support levels indicating that the price will bounce and move upward. Consequently, a bullish moving average acts as support
When the price touches the moving average line from below, a resistance level is determined, which means that the price will move downward. Accordingly, the bearish moving average serves as resistance
The graph below identifies the support and resistance levels using a moving average indicator:
It is clear that during an upward trend, the moving average serves as a price support level, and each time the price touches the line from above, it indicates an upward price movement (points shown with green arrows). On the right side, a resistance level is identified using the moving average line (the red arrow). When the price touches the line from below it signals a downward price movement.
Pros and Cons of Moving Averages
Benefits of using the moving average indicator in your trading strategies are:
Simple and easy to use technical analysis indicator
A handy indicator to swiftly determine the overall long-term trend
It can be a powerful tool when combined with other indicators
Although a moving average can be used alone, it's wiser to combine it with other indicators because of its drawbacks:
It is based on price movements in the past and as such, it doesn't account for information which can change the future performance of an asset
The moving average indicator may lag in a period of swift changes in prices, which can appear at reversals
Although there are commonly used time-frames, a single moving average set-up doesn't apply across different assets. Hence, you need to identify the best set-up for different assets if you trade multiple assets. You might need different set-ups because not all assets behave and react in the same way to changing market conditions, and there are also differences in volatility.
When you use different indicators while creating your trading strategy, you should make sure that the indicators capture multiple areas such as the trend, momentum, volatility, etc. Accordingly, the moving average as a trend indicator can be combined with indicators that identify signals through the momentum or the volatility of a price.
The 3CR Method Moving Averages
The 3CR strategy uses two different moving averages. The Sonic R Dragon uses a 34 period and an 89 period Exponential Moving Average (EMA) to measure price trend. An EMA is more responsive to recent price change when compared to the SMA which applies the same weight to all price changes in the given specific period. When the faster 34 EMA crosses the slower 89 EMA from below, it signals an uptrend. A cross from above signals a downtrend has begun.
The second moving average used is the Triangular Moving Average (TMA). This moving average is similar to other moving averages (exponential and weighted) except it uses a different weighting scheme.
Exponential and weighted moving averages assign the majority of the weight to the most recent data. Simple moving averages assign the weight equally across all the data. With a TMA, it is double smoothed (it is averaged twice) so the majority of the weight is assigned to the middle portion of the data. In this way, it is less affected by sudden swings or spikes in recent price than the EMA.
The TMA slope indicator identifies the changes in the direction of the market momentum. It also signals for possible weakening or strengthening of the trends so that traders can make their trade exit decisions. In the chart below, the dots at the end of the bars show whether the TMA slope is changing direction i.e. the TMA bars are rising or falling in value. When the dots change colour, the trend is becoming exhausted and a reversal is likely.
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