Is your trading and investing producing below average returns? If so, there may be a simple reason. The “Moving Average” is a tool that is talked about in almost every trading book that has ever been written. Every day on television CNBC, Bloomberg, and others are telling us where the S&P and other key markets are in relation to the 200-day moving average for example. Every charting package on the planet comes with every possible configuration of a moving average for you to use. Because of all this, moving averages must be one of the most important tools for traders and investors right? You start to think that it must be impossible to make money in the markets without using moving averages. When we take a deeper look into the purpose and result of using moving averages, you start to see that not only do you not need to use them but more importantly, they can actually hurt you if you don’t understand the risk that comes from using them as a primary buy and sell decision making tool and that is the focus on this piece.
Instead of going through many charts to find the perfect picture to use as an example to illustrate my logic, I like to use real trading examples from our live trading rooms. The other day, I identified a demand level in the NASDAQ (yellow shaded area). Early that morning, I noticed that price was declining to that level, offering me a low risk, high reward, and high probability buying opportunity. Once price declined to the demand level, the plan was to buy it with a protective sell stop just below the level to manage the risk with one profit target above.
NASDAQ Trade: 9/23/13
Prior to the stock market opening, price declined to the level where I bought 2 contracts in an XLT account. Price moved higher, I exited the trade for a short term income profit of $595.00. Now, let’s go over the same trading opportunity but instead of applying our rule based market timing strategy, let’s use a moving average which again, is a tool talked about in almost every trading book ever written. Most people are taught to buy when the moving average turns higher. As you can see below in the red circle, by the time the moving average turns higher, price has rallied quite a bit already which means high risk and lower reward if you use your moving average as a buy signal. Furthermore, notice that the moving average was sloping down when our rules gave me the buy signal that I actually took. Also, notice that the short term trend of price was down when our strategy gave us the low risk buy signal. Have you ever read a trading book that said to buy in a downtrend? Of course not yet this is the action you take when you properly buy and sell anything in life don’t you? This is exactly how you make money trading as well but the trading books almost always teach you to do the opposite which is a very flawed school of thought. Many of the traders following indicators such as moving averages are really smart people who have the best of intentions; they’ve just been taught wrong and given a faulty strategy. It’s not rocket science, traditional technical analysis can be overly complex, often causing “paralysis by analysis.” This is why I focus on teaching students our simple rule based strategy using the principals of supply and demand aimed to help them find “real” low risk, high reward, and high, probability trading opportunities. Waiting for the moving average to turn higher, you certainly get confirmation but at the cost of extremely high risk and lower reward. Furthermore, the confirmation that so many people seek and desire is an illusion because you still don’t know exactly what price will do next; this is all about probability, risk, and reward.
NASDAQ Trade with 20 – Period Moving Average
Again, there are so many books on trading and most people start the learning process by reading the trading books yet the vast majority of traders and investors fail when it comes to achieving their financial goals. For the most part, the books say the same thing and teach the same conventional concepts. Specifically, most of what those books teach is conventional technical analysis including indicators and oscillators such as Stochastics, Mac-D, moving averages and so on. Here is the problem… Conventional technical analysis is a lagging school of thought that leads to high risk, low reward, and low probability trading and investing. All indicators are simply a derivative of price meaning they lag price. By the time they tell you to buy or sell, the low risk, high reward opportunity has passed. They have you buying after a rally in price and selling after price has already declined. At Online Trading Academy, we don’t use conventional indicators, oscillators, or chart patterns that you read about in the trading books as primary decision making tools because adding any decision making tool to our analysis process that lags price only increases risk and decreases reward. Why would we ever want to do that? I know the information in trading books has been around for many decades but that doesn’t mean it works or helps people. Like learning anything else in life, there is the book version way of learning it and real world learning. My goal in this piece is not to beat up books and theories, it is simply to open your mind to a lower risk, higher reward way of trading and investing.
Also, do your strategy rules have you only buying when price is above a rising moving average and selling below a declining moving average like many books suggest? If so, this means you are always paying above average prices when buying and selling below average prices when selling which is likely the last thing you want to be doing. When you embark on the trading journey, make sure you have the right road map. Without it, you may be walking east and west trying to reach the North Pole and not even know it…
Hope this was helpful, have a great day.