3 Ways to Use Moving Averages in a Trading Strategy
Moving Averages, Trading Education Talking Points:
- This is a trading education article investigating systematic trading concepts and strategies utilizing the simple moving average.
- Moving averages are logical as it simply the average of price over ‘X’ periods, and it’s usually one of the first indicators learned by new traders. But, after finding that moving averages don’t ‘always work’ they move on to other more ornate indicators. But if those are also based on the past, then logically, they also lack predictive capability. Simplicity may be the best path forward as the realistic prospect of failure can exude the importance of risk and trade management.
- Below I look at three different ways to use moving averages in the trader’s approach, evolving the discussion from our previous article on the 200-day moving average.
In my last article on moving averages, I talked about the importance of the 200-day simple moving average. I had written that in early-January and one of the reasons for the timing is that I could see that it was fast coming back into the picture on several markets. And since then, it had held resistance in the U.S. Dollar for almost three full weeks, while providing support for EUR/USD for a little more than two weeks. There’s also been a 200-dma test in Apple as well as USD/CAD and AUD/USD, as well as Disney (ticker: DIS) which I look into below. When it was last in-play on spot gold, a support hold at the 200-day moving average led to a massive rip of as much as 11.12% over the next two weeks and change, illustrating how impactful this indicator can potentially be. But it’s not always going to lead to slingshot moves as it’s simply a manifestation of past price behavior, and there are multiple ways that it can bring benefit to the trader which we will investigate in this article.
Gold Daily Price Chart July 2023 – February 2024
The 200-day moving average continues to highlight major market moves or themes; but the natural next question is how a trader can use it in their own approach.
The 200-day MA may only offer a few crossover events a year, such as we saw previously, and they’re not always going to lead to strong and elongated trends. This will often get traders to move on to other analytical methods, or perhaps even over to other indicators that do offer more activity, such as an oscillator like stochastics or MACD. And while those indicators can possibly bring benefit if used properly in a broader strategy, they suffer from the same drawback as the simple moving average in that it’s solely a calculation of the past – and the past doesn’t always lead into the future. This is the case for almost all technical indicators as they’re simply based on past price information.
New stuff happens, and this is what makes life fun and exciting; and sometimes anxiety-inducing. But whether we like or not it’s unavoidable. And a trader’s strategy, particularly if heavily based on technical analysis, should assume as such.
For the trader, a simplification of their strategy can be drawn back to a simple question: Are they expecting something new to happen, or for history to repeat itself in some way? For the latter camp they’re often investigating some form of mean-reversion, or range trading; while the former group is focused more on breakouts or trend continuation scenarios.
For those that are focusing on trends, timing becomes perhaps even more important than for those working with mean reversion; because mean reversion will have a price-based failure mechanism (if support or resistance breaks it’s no longer a range) while trends can be a bit sloppier on both sides, both with the trend-side run as well as the pullback.
But there’s a rationale behind leaning towards trends and that’s largely with the reward-side of the equation. While mean reversion will have a theoretically capped upside (resistance for longs, support for shorts), a strong trend can run to higher-highs and higher-lows, well beyond what would’ve been initially expected at the outset. That’s one of the allures of trend trading and that also leads to one of the more common and popular usages of the moving average, as a trend filter.
Moving Average as a Trend Filter
I’ll say it again: The future remains uncertain, at all points in time. If there were a crystal ball that would perfectly forecast market moves, then there would probably no longer be free markets from which you or I could speculate. Instead, we’re all in the dark as far as forecasts are concerned, trying to grab on to the closest handle that we can find.
There are two large takeaways from technical analysis, in my opinion, two ‘value statements,’ if you will. The first is that support and resistance can help to hold highs and lows. It’s not perfect, but if there’s a collection of new buyers coming in at a perceived ‘low’ price, and that force is enough to offset the sellers that have driven price down there, well then, we have support. And it may hold. It also might not, but that’s not the point, because again, the future is uncertain. The very fact that we’ve found something that ‘may’ happen means we can begin working possible probabilities off of that scenario. But we’ll get deeper into that in a moment.
The other tenet is that trends take place. This is somewhat of an obvious statement, I know, but if we’re drilling down technical analysis to pure utility, it’s the identification of trends that can be of value. Fundamental analysts or traders often spend most of their time learning of, discovering, or bantering about those various reasons. The technical analyst, however, merely cares that they are there, so that they can then attempt to impart a bias into the marketplace in the direction of that trend. So that if what keeps happening continues to happen, well then, they can find themselves in a pretty attractive position.
There’s a lot of different ways to define trend, and this can even take on somewhat of a subjective nature if we’re looking at various time frames. Perhaps EUR/USD has had a really strong two days? Would that qualify as a bullish trend? Well, what if those two days were after a month of vicious losses, how about then?
So, we need a way to define trend and one simple way of doing that is with a moving average. And if we think through the logic of both trend trading and moving average construction, this makes sense. The moving average is simply the average of the past X periods, where you get to choose the value for X. If prices are strong and the trend is moving up, well then, we should see price leading the moving average higher. The longer that the trend runs, the longer that relationship will hold and the more the moving average will reflect these new, higher values.
And for a bearish market, prices moving lower would show below the moving average. And as lower and lower values register, the angle of that moving average will similarly head-lower. The entire point of the moving average is to help modulate the candle-to-candle noise that’s ever present in the field of speculation; and using moving averages to help define trend can illustrate those scenarios to traders.
This can be done in a very simple format, starting with selection of a moving average. The 200-day moving average is incredibly popular for trend diagnostics so we can investigate that on the chart below. And from there, it’s pretty easy as price below the moving average denotes a bearish trend, with which the trader can then carry a bearish bias into their strategies while price above the moving average highlights a bullish trend with which the trader can implement a topside bias.
The below daily chart of EUR/USD since April of 2020 shows how this could look if using the 200-day moving average as a trend filter. Red areas would be a bearish bias while the green-shaded areas would indicate a bullish bias.
EUR/USD Daily Price Chart
Pros and Cons of a 200-Day Moving Average Trend Filter
The primary ‘pro’ for using a moving average as a trend filter is that it can remove one of the more difficult part of setting up trades which is choosing a directional bias. Going back to what was said earlier, ‘the trend is your friend,’ but there’s a lot of different ways of diagnosing that trend. By dialing back to the 200-day moving average for grading trends, this would allow the trader to take notice of the ‘big picture’ in a manner similar to other market participants.
When using a moving average as a trend filter – it does not imply entry, merely bias. If we’re in a red-shaded area, then traders can implement entry logic with that bias in mind. So, if using RSI for entries as an example, the trader could investigate sell triggers on crossovers down and under the 70-level while ignoring bullish signals when RSI crosses up and over 30; or, perhaps they could use that contra-signal as an exit item from the bearish trade and theme. This can be done with slow stochastics or MACD or CCI or any other slew of complimentary technical indicators; or even something like pivot points.
The big downside of this arrangement is lag. There will be portions on the chart where the trend has already changed but it hasn’t yet registered in the moving average, such as we saw in Q4 of 2022, as EUR/USD was shooting higher, yet price remained below the 200-day moving average for more than a month. If the trader is trying to set up bearish trades even given that price relationship with the MA, they could have a bad time, and this would largely be resultant from the lag in the trend filter.
There’s a couple of ways to handle that. The trader can use a tighter moving average as a trend filter, such as 50 or 100-day, but then there would be the possibility of less consistency given the greater number of crossovers and a higher propensity for noise to affect the trader’s analysis.
Another way of moving forward is incorporating a second moving average, such as the 50-day moving average. The media often covers the ‘golden cross’ or the ‘death cross’ dynamic, which is simply a 50 and 200-day moving average crossover. And just like a single moving average with a price crossover, there will be lag; but if using as a trend filter this could effectively remove periods of the market in which the trend may not be favorable.
Below, I’m looking at the same EUR/USD scenario but this time I’ve added a 50-day moving average. The trader would only bias a market if the moving averages are appropriately situated, with price leading the 50 which is leading the 200-day higher for bullish trends; or with price below the 50 which is below the 200-day moving average for bearish trends. In essence, the trader could use the golden or death cross for trend filtering, looking to only focus on strong trends given the juxtaposition of the moving averages with price at that point in time.
EUR/USD: Using the Golden or Death Cross as a Trend Filter
You’ll probably notice far less color on the above chart, and that’s somewhat of the point: By tightening the filter with inclusion of a second moving average, the trader would, in essence, be attempting to focus on only the strongest trends.
There’s also the option of using a faster moving average than the 50-day, such as the 20-day. But each tweak will come with drawbacks of some sort. If the trader wants greater activity with the trend filter it will often come along with more noise. Or if they want less activity and ‘cleaner’ indications then they will probably end up introducing more lag into the equation. The goal here should be orienting the trend filter to the trader’s overall approach and what they’re going to do after the trend is diagnosed, and that’s trigger trades in the direction of the trend.
Using a Moving Average as Support and Resistance
As noted earlier I believe there are two areas of value that can be had from technical analysis. Trends are big deals because that’s a bias that’s displayed in a market. That bias may continue, and as traders, that bias can be helpful because we will never control price, only our positions, and by getting positioned in the direction of the trend then we can try to get that working on our side.
But it’s not enough to just buy and hope, is it? Because timing matters and even if a trader can pick great trends if their entry is ill-timed, well then, it’s all for naught.
Support and resistance can be incredibly helpful in market analysis and it’s largely for what they can offer the trader in terms of risk management. It’s an opportunity to implement an ‘if-then’ statement. If the trend remains bullish and if markets continue to run higher-highs and higher-lows, then the stop below the previous higher-low should remain unfettered. But – if the trend changes and the low gets taken-out, the stop can execute a closure of the position so that the trader can, hopefully, stem some of the possible damage that comes with the inevitability of being ‘wrong.’
Or, alternatively, if the low is in-place, the stop should hold. If it’s not, the stop should protect from taking a larger loss than what would be needed to speculate around a support hold.
We already looked at an example of the 200-day moving average showing as support in the chart of gold at the beginning of this article. But this can take place across markets in various ways. Below is a recent chart of Disney (ticker: DIS), and we can see where, initially, the 200-day moving average offered resistance, and then after the breakout, it came in as support, allowing for the build of a falling wedge formation. The 200-day moving average held support despite a number of tests and then, eventually, that trend-side drive got back into working order.
Disney Daily Chart (DIS) June 2023 – February, 2024
This support or resistance implication can even be tied together with broader trends. As an example of that, we can see how the 200-day moving average helped to hold support in Nasdaq futures as the trend was turning more bullish in early-2023 trade.
On the below daily chart, notice the initial breakout, marked in green, leading into a pullback at which point bulls came in to hold higher-low support right at the 200-day moving average (in blue). There were tests below but no daily closes, and then bulls took over for much of the rest of the year. But that support hold over two tests at the 200-day moving average were a key part of the build of that move.
Nasdaq Futures (NQ) June 2022-February 2024
This can even be plotted on a longer-term chart, such as the weekly. Below I’m looking at the weekly chart of Apple and notice that there were multiple periods in which the 200-day moving average came in as a support or resistance test.
Again, this will be imperfect, but using the weekly could help to eliminate some of the day-to-day noise. If price closes on Tuesday below the moving average but opens on Wednesday above, and then holds that for the rest of the week, that will look like a support test on the weekly chart. Below, I have the 200-day moving average plotted on the weekly chart of Apple.
Apple Weekly Chart April 2021-February 2024
This can be done with other moving averages, as well. Below, I’ve plotted the 20-day moving average on Apple and you’ll notice multiple instances of support or resistance showing on the indicator.
Not all inflections turn into fresh trends but that’s not really the point here: If using a moving average for support and resistance the aim would be asymmetric potential with trade setups, particularly those in the direction of the general trend, which can be diagnosed as we illustrated above with the moving average as a trend filter.
Apple Daily Chart – 2023 open – February 2024
Support and Resistance to Seek Asymmetry with Trending Market Conditions
This would be like any other permutation of support or resistance, in which the trader needs to first see some element of intersection. And then, ideally, an intra-period market response, which would leave an extended wick through the indicator, highlighting a response that took place during that bar’s formation.
I’ve highlighted two such instances on the gold daily chart below. The first, as resistance, would’ve failed while the second, as support, would’ve worked out well for the trader plotting support/resistance off of the indicator.
While a 50/50 may not sound attractive, size matters, and to the trader that could cap the loss from the failed resistance test in the red box, they could’ve offset that loss and then some with the sizable trend that developed after the second inflection, (green box) when it was in as support.
Gold Daily Price Chart
Popular Moving Averages for Support/Resistance Identification
20-Day, 50-Day, 100-Day, 200-Day
Using a Moving Average as a Trigger
I want to get this out up-front: Using a single moving average as a trigger to get into positions, without any other analysis on its own, could be a feast or famine type of prospect. The answer as to which will show will be governed by whether the trend extends in that particular case and as we’ve talked about multiple times already, there’s no way to perfectly predict that. So, the trader using a single moving average as a trigger to get into positions could fall victim to noise very quickly. If we end up in a grinding market of back-and-forth price action, that trader may end up in a downward spiral type of drawdown as they’re constantly trying to chase a trend that hasn’t yet developed.
However, with a bit of context this could be addressed. I’m going to take the same chart we looked at above with gold and the 200-day moving average, but now I’m adding a 20-day moving average that can be used for trend-side entries. So, if price is above the 200-day moving average then the trader would bias the market as bullish, at which point they would look for a closed candle going up and over the 20-day moving average to trigger in the direction of that broader trend.
By nature, this would likely happen after a pullback of some sort, as the math of the situation would illustrate that strong trends show price leading the 20-day moving average and both are leading the 200. If price gets back below the 20 but remains above the 200, well then, we’ve probably seen some form of retracement. And sure enough on the below chart many of those instances can be described as such.
Gold Daily Price Chart June 2022, February 2024
There are two main takeaways from the above chart: 1) Not all entries are perfect as there’s multiple examples of failure in the above chart. 2) there are multiple setups that led into strong momentum-driven continuation in the direction of the dominant trend.
Again, the point here is not perfection. We’re looking at the past. The past does not predict the future. The aim here is to try to align probabilities as much as we can given the information available, and if a strong trend develops then the trader can find themselves in an attractive position, particularly if they’re using asymmetric risk/reward ratios and trends take hold for long enough to allow for movement to reward targets. If it doesn’t, then, ideally, using trend filters or relatively tight stops on support/resistance inflections can help to obviate some of the pain from those adverse situations.
But if the market does trend, a simple setup like a moving average filter with a shorter-term moving average trigger can look very effective. I’ve applied the same setup on the below EUR/USD chart.
EUR/USD Daily Price Chart July 2021 – February 2024
I want to again highlight, the strategies discussed in this article are not perfect, nor are they an attempt at building some type of ‘holy grail.’ The reality is that forecasting is messy and often noisy. The aim of the trader is to align with market themes as well as possible given the context at the time; and with the future retaining a degree of uncertainty, these methods can help traders to try to buy up-trends ‘relatively cheaply’ after a trend pulls back, or after a major moving average shows an element of support or resistance at a spot that others may be also watching. The trend filtering from the moving average(s) can be very helpful for biasing based on recent market activity, and traders can use one of these methods or all three together.
--- written by James Stanley, Senior Strategist
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