As traders, we have to take into consideration many things. We have to implement different factors and indicators in our analysis in order to succeed in this business, no matter if you trade short or long term. These might be fundamental indicators, technical indicators, or both. On the other hand, we shouldn´t overcrowd the charts with too many indicators that will contradict each other and cloud our judgment. I have seen many traders, especially newbie ones that overload their charts with all sorts of lines and indicators,
becoming a burden for traders instead of helping them. When you look at these charts you don´t really know what you´re looking at, they look more like matrixes from the future. We shouldn´t complicate trading more than it already is. Charts should be easily understandable and the indicators should be simple to interpret. Simple indicators work better because more traders use them, therefore the possibility of trades based on these indicators going the right way increases.
One of the simplest indicators is the moving average (MA). It is easy to interpret and can be placed on the chart so you don´t have to make calculations, you just wait until the price gets close to it and then decide whether to buy or sell. They act as cushions to the price, providing support and resistance. There are four types of moving averages; simple, smoothed, exponential and linear weighted. You don´t have to guess what moving average to use, you just look at the chart history and see which ones have worked best in the past, that´s what makes this indicator so easy to use. Personally I use three or four moving averages on my charts. As we said above, we should keep it simple even when it comes to moving averages, so I use round numbers for them. I put in my charts 50 simple MA, 100 simple MA, 100 smoothed MA and 200 smoothed MA. Sometimes during strong trends and in the smaller time frame charts I throw in the 20 exponential MA as well. They can be applied to the opening or the closing price of a candle, but it is advised that you apply them at the closing price. The numbers for the moving averages show the number of candles used to calculate them. For example, for the 50 MA in the hourly chart, the closing price of last 50 candles has been calculated. But you don´t have to know how to calculate them, because all brokers offer this indicator with their platform, you just need to know how to use them for trading.
Defining trends
Ok, so let´s start with the important part, which is how to trade based on moving averages. A moving average is a useful tool for indicating a trend. If the MA is below the price we are in an uptrend, if it is above the price then we are in a downtrend. If the price is below then moves above the moving average, we can consider a change in the direction of the trend. For a better confirmation we should wait to see it move past a higher timeframe MA, that´s why I use more than one moving average. The USD/CHF daily chart below shows that during the first few months, the price was ranging below the 50 MA in yellow and 100 simple MA in green. It broke the 50 MA on the fourth month, which indicates that an uptrend might begin. But as we can see it had done so a few times before, that´s why we should wait for a break of the 100 MA to be sure that an uptrend is being formed. About one week later it broke the 100 MA, confirming the uptrend. Later that year the price pierced the 50 MA three times during the uptrend, which means that the trend might reverse, but it hasn´t closed below the 100 MA, therefore the trend remains intact. These are fake outs that we should be aware of and this is another reason why we should use more than one moving average.
Another safer way to spot trends using moving averages (MA) is the cross over strategy. In this strategy only two moving averages are used, usually 10 and 20 MAs. We know that the smaller MA moves faster and it is bound to cross over the other MA once a trend begins, hence the name of the strategy. In our case the green line crosses the red one. When this happens the trend is confirmed and we should enter in the same direction. This is a more lagging strategy than the first one, which means that there´s some delay in spotting the trends. So we might get in a trade when the trend is nearly over, that´s why this strategy is usually used on long term trading.
Providing support and resistance
Both strategies we explained above are lagging ones and moving averages work well on them, but I'd like to use MAs especially as leading indicators. Moving averages are very useful tools for providing resistance and support to the price on an uptrend or downtrend. Again, it is better to use at least 2-3 moving averages for this strategy; because once one MA is breached another one comes into play. We all know that the price doesn´t go up or down in a straight line. Instead, it makes a move up, corrects for some time, then it resumes the up move again. Quite often corrections are bigger than our equity so, if we want to buy in an uptrend we should wait for the correction to be over. But how do we know when the correction is done? That´s when moving averages come in handy. It works best when we add another indicator like Stochastics or RSI to this strategy. The GBP/USD chart below displays this strategy perfectly. During the uptrend on the daily chart, the price has made several corrections, retracing to the 50 or 100 MAs. It might touch the MA or get close to it; nothing works exactly to the pip in this game, that´s why we need to give it some room when placing the stop. On the same time Stochastichs have reached the oversold level. This is the confirmation that the retrace is over, so that´s when we should buy. We should place the stop to a reasonable level below the MA, depending on the pair and on the timeframe.
50 and 100 MAs provide support in the daily chart
20 exponential MA provides support in the weekly chart
It would be safer if these corrections correspond with the price touching a moving average on another timeframe chart. The weekly chart above is of the same pair during the same uptrend. We see that the price touches the 20 exponential MA at the same time when the corrections seem to be over on the daily chart. Some traders use daily charts, while others use weekly ones, so when they correspond it makes the resistance even stronger, because both groups buy the pair, therefore sending it higher. During strong trends, the smaller period moving averages are the ones that provide support/resistance. Then when the trends get weaker, these MAs are broken and the bigger period MAs do their job, so we should be careful when we decide to open positions after the trend has slowed. The EUR/GBP chart below shows that the 20 exponential MA has provided resistance and good sell opportunities during the strong downtrend. When the trend slowed, the 50 and 100 simple MAs, as well as the 100 smooth MA took their turn to provide resistance.
20 MA acts as resistance during the strong downtrend in the first half of the chart. The 100 simple and smoothed MAs act as resistance when the trend gets weaker
20 and 50 MAs provide resistance in the beginning, but turn in support after they´re broken
We can say the same thing for trends that are slower but pick up the pace later. In the beginning the longer period MAs provide support, but when the trends get stronger the smaller period MAs take their place. Another thing we should know is that the MAs provide resistance, but after they´re broken they turn into support and vice versa. We can see this in the very beginning of this chart, where the 20 and 50 MAs have acted as resistance in the beginning, but have turned into support after the price moved above them.