By Gabe Velazquez, Online Trading Academy E-Minis Instructor
In the last few newsletters I've written, there have been numerous examples of moving averages being used for exiting strategies, trend identification, and the like. This has spurred many email inquiries about how I use them for my own trading. I'm also asked what length should be used, and whether to favor a simple or exponential moving average.
In this letter, I'll attempt to answer some of these questions, give some examples, and perhaps give readers another tool they can evaluate for their particular trading approach.
First, I'm going to assume that most readers have a basic understanding of moving averages. Even so, understanding the difference between an exponential and a simple moving average is one area where I find that many people are unclear about. So with that in mind, let me begin with a brief explanation of how a simple moving average is drawn.
In the days before computers, technicians would simply add the closing prices for a given period (let's say 10 Days) and divide that number by 10. So in this example, we would require at least 10 days of data to begin plotting this particular moving average. To continue plotting the line we would add days 2 through 11 and so on. If price rises, then the slope of the line would follow suit, thus indicating an uptrend.
With the advent of computers, technical analysts went to work enhancing this old classic moving average. In an effort to reduce the lag associated with the SMA, they began using a slightly different calculation in which more weight is put on the most recent prices, vis-a-vis older prices. Hence, we have the creation of the exponential moving averages.
In the chart below (Figure 1), I've applied both a 50-day SMA and EMA to the daily TF (E-mini Russell 2K). Note that the distance between actual prices is far less for the EMA than it is for its slower counterpart.
Figure 1
Also, keep in mind that moving averages are most useful in a trending environment, so one must recognize that using this tool in range-bound markets will not yield great results.
When it comes to the settings to be used, this will be predicated on various factors. The time frame and financial instrument play an important role as to the length of the MA being used.
Case in point, institutional traders keep a close eye on the 50 and 200-day simple moving averages as a measure of whether to be long or short stocks or the market in general. They also look at this particular technical indicator as an average mean. In past articles, I've discussed the propensity for the market to overshoot (move away from the mean) and eventually work back to the average. This phenomenon has even received some notable mention in technical circles of late.
What I'm referencing specifically is the fact that this week, the S&P 500 traded roughly 33% below its 200 simple moving averages (see Figure 2) which is an extremely rare incidence (only three times in the past 50 years). The most recent occurrence happened back on November 20th of last year, and twice between 1927 and 1937. On all these occasions, a sharp rally ensued. Whether or not this will happen again is anyone's guess. In times like these where most precedents are being shattered, nothing is surprising anymore.
Figure 2
My use of moving averages is largely as filters. That is to say, that depending on where price is located relative to the moving average, I will look to trade in the same direction.
The chart below illustrates how the MA's provide a filter signaling us to look only for shorting opportunities, as price never closes above either moving average. The short sales would be done at the highlighted resistance areas.
Figure 3
In addition, notice there are two moving averages. The faster one (red) can be used to exit steeper trends, and the slower (blue) MA can be used as a resistance level to confirm the trend.
In this depiction, the slow is a 60-period exponential moving average and the fast is a 25-period EMA plotted on a 5 min chart. These particular settings work well on this futures contract.
As I've stated in prior newsletters, one has to try different settings to find ones that work best for the specific stock, Forex pair, or futures contract that is traded.
The best way to determine whether a specific setting is optimal is by visual observation of a trending pattern, and assessing how price reacts to the particular length being applied. As you can see in the chart above, price tends to be attracted to the moving averages.
One last observation regarding moving averages: Although most traders are told that the trend is their friend, take notice that when price has moved a considerable distance away from the slow moving average, the reward to trade in the direction of the prevailing trade has appreciably lessened. Therefore, it's best to wait for a retracement or take countertrend trades when this occurs.
As with any technical indicator, moving averages should not be used standalone. There should be rules attached to their utilization in order to compliment setups. And, they have to be tested to add a level of confidence before they're implemented.
Until next time, I hope everyone has a profitable week.
If you have questions, comments, or you would like a specific topic covered, please email me at gvelazquez@tradingacademy.com
- Gabe Velazquez
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