Last updated on October 13th, 2020
Moving average trading strategies are a staple for many traders.
Whether trading Forex, Futures, Options, Stocks, moving averages can do everything from showing trend direction, to a full trading strategy.
In this trading tips post, you are going to learn the better way to use moving averages for:
- Trading the crossover of the moving average
- Using the moving average for a pullback trading zone
- When to stay out of the market
Moving averages while being a lagging indicator, can be useful if you use them the right way.
How Useful Are Moving Averages For Trading?
We’ve heard that moving averages act as “dynamic support and resistance“. While that sounds appealing, the average is simply a price calculation that gives the illusion of holding price.
When the average price over the last X periods decreases, you will see price and the moving average get closer.
Larger average price, the gap between price and the average increases.
When the price and average get close, traders look to enter in the pullback to get onboard the prevailing trend.
How close is close enough?
- Do you need price to actually touch the moving average?
- Is close, close enough?
- How do you define close?
Those questions have to be part of your trading plan.
- Trend following using moving averages can get you into the new trend extremely late depending on momentum moves.
- Many different types of averages to chose from – exponential moving average, simple, Hull moving average……..
- Many different setting combinations
Getting into trading with a moving average can have traders going down the rabbit hole looking for the best setting.
There isn’t any.
The key to moving averages is knowing that short term averages (3,5,10) will react quicker to price than a longer term such as a 50 period average, 100, 200.
Are averages useful?
Moving averages will smooth out price action and give you a quick indication of trend direction. When price chops around a moving average, we can usually find a trading range. Pullback trading (return to the mean) can be used with moving averages as a gauge to market momentum and zones of trading opportunity.
20/50 Moving Average Trading Strategy Outline
There is nothing overly special with the 20 SMA and the 50 SMA (simple moving average).
You are just looking at a shorter term average paired with a longer average that will show a more persistent trend.
Instead of using a 20 period moving average, you are going to use the Keltner Channel (Simple setting) set to 20 periods with a multiplier of 1.
In Tradingview, you can set the background color under “style”.
You Need To Define Trend Direction
We are trading in the direction of the trend and to do so, we will use the crossover of the averages.
- When the 20 SMA of the Keltner crosses up and over the 50 SMA, we are looking for buy signals
- 20 SMA crossing down through the 50, we want sell signals
- When the moving averages are crisscrossing and price is chopping back and forth, we have a trading range
On the above daily chart of the stock Apple, we can easily tell the market is in an uptrend. Traders would find higher probability trades when looking to trade to the long side.
What Is Our Trading Setup?
Once we have determined our trend direction, we now look for a setup and in this strategy, pullbacks are our strategy choice.
While pullbacks to moving averages is nothing new, we are looking at pullback zones. Price will pullback to, past, and near, the moving average so we need an objective way to measure a zone.
Enter the Keltner Channel
We want price to pullback into the 1 ATR (average true range) zone of the Keltner Channel.
Not only that, we want to be able to enter the trade prior to price moving more than 1 ATR away from the 20 period average.
The trading zone is highlighted on this chart but there is a problem: price pulls to the zone but closes above it.
In this run in the market, we don’t have a trading entry as price was closing above the blue ATR zone. The price action would be tough to sit through as it grinds higher.
You can see that the moving averages have, generally, the same distance apart which means there has been no big increase in price movement. If there were, you’d see the blue line pulling away from the black line.
Trading Setup Begins
Price continues to grind higher until we see a pullback into our zone a few days before earning release.
Price has pulled into our zone and has actually travelled roughly 2 ATR from our midline. The 50 SMA is still intact and there has been no average cross to change our trend direction.
We have a valid pullback but we only have a trading setup.
We need an entry trigger to get us into the trade.
There are many types of trade triggers we can use and this chart actually has an obvious reversal candlestick.
Let’s look at a few other entry triggers for this chart.
Here we have on the left, the daily chart and on the right, the four hour time frame.
We already talked about the reversal type of candlestick to enter but also consider a two or three candlestick pattern.
On the daily chart:
- Price pulls into our zone and we look to see the low taken out which happens on this chart
- This could be our entry candlestick if the closing price would have closed higher than the close of the first candle.
- This is the entry trigger as this closing price closes higher than the candle at number 1
- On the four hour chart……Enter on the break of this trendline
- Enter when price closes above the 50 SMA for a long setup
- Enter when price closes above the 20 as long as it’s inside the blue zone
The key is seeing price pull back into our blue zone and looking for a trade entry trigger.
Forex Trading Moving Average Example
On the left of the chart, price is pulling into our zone and are legitimate setups. You may decide to use the daily time frame or use a lower time frame for trade entry.
The averages cross to the upside and we see a separation in the moving averages. You can see by price this is momentum and a strong trend.
A long trade setup occurs and you would use a trade trigger to enter.
On the right side of the chart, our rule of only taking trades when your entry is inside the blue 1 ATR zone, keeps you from buying highs. There is one section, marked by the green arrow, where we have an entry. Price moves 167 pips from that zone, more if you have a lower time frame entry, which is enough to manage a trade.
We Need A Stop Loss
There are many ways to set a stop loss and I’m not going to go in depth in this post.
However, you do want a stop that allows some wiggle room for price to move. Consider ATR stop loss zones, support zone, and resistance areas.
The rule we have is to set your stop loss in relationship to your trading time frame, not your trigger chart time frame.
If using a daily for setups and four hour for triggers, use the daily for your stop loss.
Profit Targets For This Strategy
Like a stop, price target zones come in many different variations.
Some traders will use a multiple of their risk while others will use defined zones on the chart.
Targeting swing highs in an uptrend or lows in a down trend, is not a bad way to begin to manage your trade. Some traders may want to use a technical indicator to take profits.
You have to decide on a profit taking strategy that you are comfortable with.
This is a simple moving average strategy that you can start testing today.
The most important points are:
- Trade in the direction of the moving average cross
- Price must pullback at least into our trading zone
- Use a trading trigger for every single entry
When making your trading plan, ensure you also add in how you will determine your stop loss as well as your take profit criteria.