Moving averages are one of the most popular technical analysis tools for traders. Trading strategies based on moving averages are popular as they can be tailored to fit any period, therefore they’re considered ideal for both long-term and short-term traders.
Moving Averages for Trend Analysis
Moving averages provide valuable information on the direction in which a market is moving. If the MA is angled up, then the underlying price would always be trending in an uptrend. When angled down, that implies price is moving down. Conversely, when the moving average is moving sideways, then the price is likely to be in a range.
In the chart above, it is clear that a trader would be looking for buy opportunities whenever the 10EMA is above the 20EMA, as the short-term EMA follows price closely. Likewise, whenever the 10EMA is below the 20EMA, then the trend is downwards, signalling the best time to look for sell opportunities.
The Moving Average for Support and Resistance
In addition to indicating the direction that the price is moving, moving averages can also act as support and resistance levels. Whenever price bounces off a moving average, then it can be interpreted as a support or resistance level depending on the direction of flow.
For instance, the chart below shows price rallying higher upon touching the moving average, which appears to be a support level.
As you can see in the image above, the price continues to trend up as the moving average edges higher. Conversely, whenever the price is moving down, the moving average will also start to move downwards.
Moving Averages for Overextended Markets
Moving averages are also ideal indicators for identifying overextended markets, which could either be overbought or oversold. While trading, it is important to avoid buying or selling securities that are overbought or oversold.
As seen in the chart above, a price is considered overbought or oversold whenever it’s far off the short-term moving average. For instance, in the chart above, the price extended below the 10EMA, triggering an oversold situation. In this case, it’s important to wait for the market to normalise and come back close to the moving average to consider an entry position.
Moving Average Trading Strategy
A popular moving average trading strategy involves using three types of exponential moving averages: 5, 20, and 50 EMA’s. In this case, a trader can open a buy position whenever the five-period exponential moving average crosses the 20-period moving average from below. The 5-period and 20-period moving averages must also be above the 50-period EMA to open a buy position. A trader can also place a stop-loss order below the 20-period EMA, or 10 pips from the entry price.
Likewise, a trader can open a sell position whenever the 5-period exponential moving average crosses the 20-period exponential moving average from above. The 5-period and 20-period exponential moving averages must also be below the 50-period moving average to open the sell position.