This tutorial is the beginner’s guide to learn technical indicators such as Moving average to build trading strategies.
Table of content
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What is technical indicator?
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What is moving average?
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How moving average helps in understanding market trend?
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Different types of moving average
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Moving average trading strategies
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Problems in using moving average
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Most common mistakes done while using moving average
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Conclusion
What is technical Indicator?
Technical indicator is a statistical way of understanding the market. Technical indicator uses market data such as price, volume and open interest to arrive at the trend of the market. In this section we will be learning one of the most commonly used technical indicators – Moving average.
What is Moving Average?
Moving average is one of the most commonly used technical indicator by traders to analyse the trend of the market. Moving average is calculated by taking the average of past closing data prices. For example, 20 day moving average calculates the average price for last 20 days
How Moving Average helps in understanding market trend?
Moving average works best in trending zone. So, moving average is used for determining the market trend.
a) Bullish trend
When the current market price is above the moving average, then it indicates that the market is in bullish trend. For example, if current market price is higher than 5 day moving average then it indicates the short-term bullishness in the market.
b) Bearish trend
When the current market price is below the moving average, then it indicates that the market is in bearish trend. For example, if current market price is below 5 day moving average then it indicates the short-term bearishness in the market.
Different types of moving average
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Simple Moving Average (SMA)
Moving average also known as simple moving average is calculated by taking the average from its closing data points. SMA indicates current trend of the market but cannot predict future trend of the market. So, SMA or moving average is known as lagging indicator.
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Exponential Moving Average (EMA)
Exponential moving average is built as the progression to simple moving average. Exponential Moving average gives more weightage and priority to the most recent data points in calculating the average. Whereas, simple moving average gives same weightage to all the data points.
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Volume Weighted Moving average
Volume weightage moving average gives priority and weightage to the volume of the data points taken in calculating the moving averages.
Moving average trading strategies
Strategy 1: Using price and Moving average cross over
Moving average crossover strategy is one of the main and most commonly used trading strategies by traders. Crossover strategy gives buy signals when the market price is higher than the moving average crossover and gives sell signal when the market price is below the crossover.
Strategy 2: Using 2 moving average (fast and slow)
Traders generally use two moving averages to determine the market trend. For example, first moving average would be 10-day MA (fast). This 10-day moving average reacts quickly and fast to the current market price and the next moving average is 200- day moving average(slow) which reacts slowly to the current market trend. Traders use this strategy to determine both short term and long-term trend of the market.
Strategy 3: Using 3 Moving average
To avoid false trade, traders use 3 moving average to determine the trend of the market. This strategy works best for long term trader but it comes with a drawback that, this strategy is a late indicator of the current market trend. Most commonly user MA parameters 50, 100 and 200.
Strategy 4: Golden Cross
When all the three moving averages coincide at a point then, it gives a strong signal that the market is either moving in upside direction or in downside direction. This strategy is known as 3 moving average crossover or golden cross strategy.
Watch this video tutorial – How I use moving average and Bollinger bands for profitable trading strategy.
Problems in using Moving average
Moving average being a trend following indicator, it doesn’t work in sideway market. in general, most of the time markets are in sideway direction. Active investors must be very patient during market sideways before applying moving average. Moving average indicator is often known as late comer because is indicates the change in trend of the market only after it has actually taken place in the market.
Most common mistakes done while using moving average
Most of the beginner traders often change the parameter(days) of the moving average in order to predict the trend of the market. Traders experiment with different days of moving average and if they find any of the moving average works well in the market then, they try to adapt it and use it everywhere. This approach is not the correct way because, if 10-day MA work best for this month then there is no guarantee that, it will work next month also. Changing just the parameter(days) is not a good idea.
Conclusion
Moving average works in trending market only and it fails to work in non-trending zone. To overcome this difficulty, the concept of standard deviation is incorporated in moving average which forms a new technical indicator known as Bollinger Bands. Building trading strategies using Bollinger bands may be a topic to be discussed in coming days but one last thing traders must keep in mind while using moving average is that, moving average is not a trading tool but just a trend analyser.