As the Technical Analysis arsenal evolves, there are now countless indicators available and the number is still increasing as you read this post. Despite that fact, I can confidently say that few have proved to be useful and reliable as the Moving Average(MA).
1) Type of Moving Average
There are 4 types of Moving Average as far as I know: namely Simple, Exponential, Smoothed, and Linear Weighted.
To be honest I don’t even know how the last 2 are calculated^^
Simple Moving Average(SMA): Check out the video here
Exponential Moving Average(EMA): Same video above.
The Simple MA is slower and more stable. On the other hand, the Exponential MA reacts faster to price change as it put more weight on the latest prices.
2) Choose type of price to calculate the Moving Average:
As we discuss in the Candlestick chapter, there are always 4 types of price available: high, low, open and close. The majority of traders use the close price for Moving Average and actually for all other indicators.
I personally use close price to plot any indicators in my trading. Hence, my suggestion for the newbie is definitely the Close Price. Over time when you become familiar with the market, you can try to test everything you like but for now to keep it simple and save you the time to learn some much more valuable knowledge, JUST USE THE CLOSE PRICE !
3) Choosing the day period
You are encouraged to try adjust the period to fit your trading flavors :D. One hint is that some traders love to use the period which is a Fibonacci number ( 5,21,55 etc..)
Here is my recommendation for each market:
US Stock Market: SMA 20, SMA 40, EMA 55
VietNam Stock Market: SMA 5, SMA 10, SMA20
Forex market: EMA 21, EMA 55.
MA with lower period days tend to react much quicker to the market compared to the high period MA. Hence, we often call MA with lower period Fast MA and slow MA for the higher period MA.
** On financial media, we often see the presence of MA 200 days. It is only used for a very long-term strategy but I personally don’t like to use a lagging indicator in the long-term as Fundamentals rule everything in the long-term not a lagging indicator.
4) Moving average acts as support and resistance
The most important application of Moving Average is the provision of support during the uptrend and resistance during the downtrend. In turn, Moving Average provides a relatively good entry point for our trade. Let’s have a look at an example:
Figure 1 is HPQ Daily chart with an Simple MA 40 days. You can see the price bounces back up every time it touches the MA. If you are planning to jump in the market and ride the trend then all the red arrows are the good points to get entry.
And just like every support, we will have a resistance once a support is broken. Just scroll back the chart a few years. This is the HPQ Daily chart with a downtrend. You can see the resistance force provided by the MA. Points marked with red arrows are good entry for short position.
So why we need to take the entry near a support? The answer is very simple. If you buy or sell at a random point in the trend, you might end up seeing price run against your position in a few weeks (Look at points marked with A on the above examples). After that price might be luckily back in your direction but it is only after some heart palpitation and some protective stop being triggered. Trading is about avoiding pain so don’t give yourself some sleepless nights with a random entry point. Believe me, even with a good strategy, you still probably can’t handle the stress and anxiety in this market so don’t start the trading career with some stupid random entry point :D.
5) Moving Average Cross Over
Using the support and resistance from MA can only give you the reward which is a part of the trend. If you are kind of risk-taking traders, you might want to consider aggressively buy and sell on the MA crossover, which in turn will give you a tremendously profitable trade in a trending market.
Strategy: We will plot 2 MA on the chart. One with lower days period (the faster one). In the next example I will use SMA (20 days- green) and SMA (40days-violet).
Buy signal: When the faster MA cross the slow MA from the below.
Sell signal: When the faster MA cross the slow MA from the above.
6) Convergence and Divergence
There is one more thing, which is not reliable about MA but has been talked about by some traders online. It is when the faster MA moves too ‘fast’ and make abnormally big vertical distance with the slow MA, the market is expected to correct the fast MA back to near the slow MA.
There is a problem with this application. It is unclear how much big is abnormally big ? Hence this is not a good way to use MA in. Just read for your own knowledge but be careful before using it.
7) When the MA won’t work?
By now, the example of NIKE stock might be already giving you a feeling of wealth and rich lol. It’s time to get back to the ground and know the risk we will be facing when take the entry with MA crossover.
FB stock trends sideway (choppy) for 4 months. Anyone try to buy and sell on MA Cross over signal will end up with a loss for sure. The power of MA is to ride the trend and now we see no trend , too bad !
Ok so you might now start thinking “Hey Whirlpool, you talk too much! Now show us what we should do with the MA Cross Over strategy”. What I can tell from my experience with this strategy is that you need the courage to bear all the loss when the market trend sideways ( which is just some small loss) to wait for a big fish ( when the market does trend). History has proven that trend riding strategy was, is and will always be the most profitable one in the whole TA. The only hard part of the strategy is the requirements of patience and courage to stand still when the market trend sideways.