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That is a common problem among investors. They are looking for best working moving averages. But do you know there are few ways you can use moving average in your trading plan?
Do moving averages crossovers works?
Take ten new traders and tell them to create trading system and I am sure that more than 70% of them will use moving average crossovers as a part of their system. It is not a surprise. Moving averages are one of the oldest technical indicators. They are in use since 20’s of XX century so almost 100 years. Of course, over time people find more sophisticated ways of using them. Also, we have many more types of averages, but the concepts behind creating them are still similar.
But do they work?
From the beginning of using ma’s traders were trying to find profitable crossover signals. You may be familiar with concept such as Golden Cross and Death Cross. But there is no one simple answer to the question. When there is a strong trend then signals from moving average crossovers work great:
When there is no clear direction – the market is moving sideways or what’s worse is very choppy, then quality of buy and sell signals from moving averages is very low:
So it depends more from the way you are going to use averages – does your trading plan takes such a scenario into an account?
But wait, there is another way of using moving averages.
I started from crossovers topic because many new traders think that this is the main way of using them. They are wrong. Below you can find few examples how you can use averages in different ways.
Moving average as a trend detector
You simply take longer time frame and observe where the price is. So, in the example below we are looking at 200 moving average. When price is above that average then that is a signal for us that the overall trend is up:
When price is sitting back below average for most of the time, then it’s sign that sellers are stronger now:
What is the direction of average?
You should also pay attention at what direction moving average is pointing. If it’s pointing up, then there are better chances that trend up will continue.
When it’s pointing down then it is possible, that there is a correction taking a place or down trend will continue to expand.
Is price crossing through moving average?
This is also a valid signal. When price for most of the time was right below average and suddenly is crossing through to the other side than it is a sign that overall sentiment may be changing like in the example below:
Moving average as a support or resistance
That is a very important function. Some averages are commonly used by traders, for example 50, 100 or 200 averages. They are very popular and when price is moving near them then you can expect reaction. If price was most of the time above average, it is possible that there will be support. Check the example below:
On the other hand, if the price is below averages and is moving closer to them, then it is possible that averages will work as a resistance area.
As you already know, knowledge about possible support and resistance areas is very worthy. You can write this into your trading plan and close trades at better moments.
How many averages should you use?
It depends strongly from trader and trading style. For beginners, I suggest to put on chart at least one average from each group.
We can divide averages in three main groups:
- Short-term group – averages from around 1 to 20. They are helpful when you want to check the current short-term trend.
- Medium term group – with averages from around 20 to 50.
- Long term group – averages from period from 50 up. With long term averages you can see better the bigger picture.
Periods may be different for some traders. The values from above are there to give you some idea about scope of each group. So, you just want to have one average from short-term group, one from medium and one from long term group. You may create set like:
- 10, 50, 200
- 5, 33, 100
- 7, 21, 200
- any other combination
I think that the good start is to use 13, 50 and 200 moving average.
Test it and see which one is the best for your trading plan.
Other tools based on averages
There are many trading strategies based on averages. Most popular use of averages are Rainbow Moving Averages and GMMA. Let’s have a closer look.
Rainbow chart is very popular; you can find it in many trading platforms. If there is no Rainbow chart, then you can build it by yourself.
How? Rainbow is usually constructed from moving averages with period range 2 – 200. It may be something like averages 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15 … and so on. For averages from higher groups distance is wider, that is why in last group we have 125, 130, 135… Or if you need numbers for all rainbow averages, here you go:
- 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15 – 1st group
- 17, 19, 21, 23, 25, 27, 29, 31, 33, 35, 37, 39, 41 – 2nd group
- 44, 47, 40, 53, 56, 59, 62, 65, 68, 71, 74 – 3rd group
- 78, 82, 86, 90, 94, 98, 102, 106, 110, 114, 118, 122 – 4th group
- 125, 130, 135, 140, 145, 150, 155, 160, 165, 170, 175, 180, 185, 190, 195, 200 – 5th group
Usually they are divided into 4 or 5 groups. You may have for example groups like:
- Averages 2 to 15 – red color
- Averages 17 to 41 – yellow color
- Averages 44 to 74 – green color
- Averages 78 to 122 – blue color
- Averages 125 to 200 – violet color
Or you can use different colors, they are here only to separate visually each group.
You can use type of averages which is best for you. I use in most cases exponential averages or linear weighted averages.
The idea behind Rainbow
You can see that this is a simple tool. It helps you to check current situation. Obviously, this is a tool for traders who want to trade with trends. With Rainbow tool, they see current trend. Also, there is an information about support and resistance areas. Wide Rainbow means that support / resistance is strong, narrow that it may be weak.
Like other tools which help with catching trends and it is great with that. As always, problem is with range moves. There is a big risk that you will overtrade when there is no clear trend in place. In situations like this you will notice that Rainbow is narrow and it is changing directions a lot. Like in the example below:
You can see right away that Rainbow is rather flat and price is moving up and down. Thing with range moves is that it is rather hard to spot them in the beginning. After a while, like in chart above you know that you are dealing with range move. Before that it is not so obvious.
It comes with practice. Check higher time frames, use trend lines so you have better understanding of current situation.
From my experience with Rainbow tool I can tell that it is best to join them with other indicators. For example you may build you r strategy around Rainbow and MACD, you can add also Pivot lines. Below you can see Rainbow with two Ichimoku Kijun Sen lines (Kijun set to 26 and 60) and Pivot points.
You can mix Rainbow with other trading tools you like most. Overall, in my opinion Rainbow can be very powerful when joined with other tools with good trading strategy.
On this 1-hour EUR/USD chart we can see rainbow averages, two Kijun Sen lines (26, 60) and MACD oscillator.
After long uptrend, there was a strong move down. Was it a change in trend? We can see that longest averages gropup (violet) is still wide in this place, like other groups. This is not a good place to go short. You can close position here but it looks like trend is up. Situation like this is not rare and with help of Rainbow you can trade in right direction and you can avoid trading against main trend.
Later we can see that blue Kijun line crossed again with second Kijun and EUR/USD moved higher – this was a good point to go long again.
On this 30m GBP/JPY chart we have Rainbow, two Kijun lines, daily Pivots and oscillators.
You can see that break below support was a start for a strong move down. You could enter at the break (because earlier trend was also down and it was a correction up) or wait for reenter later. This is a good example that Rainbow is trend indicator (we know how strong is trend, direction) and longer Kijun line is our trailing stoploss line. Thanks to that you can maximize profits from your trades, because you will stay in trade as long as possible.
We have here 4h chart of AUD/NZD. Earlier trend was down. Then it looked only like a correction move but we can see that price failed to close below Kijun lines. Also, Rainbow lines were getting more narrow. It could be a start of a range move but it turned out to be a start of move up.