Whether it’s Indian or global markets, some technical indicators are considered as foundation concepts. No Wonder, most traders in India use moving averages for buy and sell signals. Intentionally moving averages were created for the purpose of understanding Market action and Price dynamics.
Trading Moving averages and their buy – sell signals, is a useless technique and it doesn’t works. Why? Because Moving averages are created for different reason, than they’re used. Price action traders utilize moving averages in a different way altogether; they don’t rely on moving average cross over signals, instead their focus is on understanding market structure and price action with the help of moving averages. In true essence, Moving average is a valuable technical tool if you know how to use it.
Best Moving Average for Daily Chart
Moving averages are widely used in practice of technical analysis. They are a basic tool with a broad set of uses. Price action traders use moving averages to find trend, to determine levels of support and resistance, to spot price extremes, climatic market movements, understand market structure etc. There are literally lots of ways; price action trading can utilize moving averages, I didn’t write all of them in this article due to Page limitations and time issues, but I do cover them in my Price action trading course.
Let’s look at three basic ways that price action traders use Moving averages.
To Determine Market Trend
The most common usage is comparing the current price with the moving average that represents the investor’s time horizon. For example, many investors use a 200-day moving average. If the stock or market average is above its 200-day moving average, the trend is considered upward. Conversely, if the stock or market average is below the 200-day moving average, the trend is considered downward. Moving average tends to follow the trend line fairly well. The moving average then becomes a proxy for the trend line and can be used to determine when a trend is potentially changing direction, just as can a trend line. In the chart, for example, the later prices have held at both the trend line and the moving average. Take a look at the Nifty chart below.
To Determine Key Support And Resistance Levels
The moving average often acts as support or resistance. As you can see in the chart of Bank Nifty at bottom, moving average often acts as support and resistance; therefore, it can be an easy trailing stop mechanism for determining when a position should be liquidated or reduced. In addition, price action seems to reverse when it touches the curve of moving averages. Most market participants such as floor traders, Institutional investors use moving averages to time their entries and exits, this maybe the reason moving average acts as support and resistance.
Identifying Price Action Extremes And Climaxes
The moving average is an indicator of price extreme. Because the moving average is a mean, any reversion to the mean will tend to approach the moving average. For trading purposes, this reversion is sometimes profitable when the current price has deviated substantially from that mean or moving average. Price has a tendency to return to the mean. Thus, a deviation from the moving average is a measure of how much prices have risen or fallen ahead of their usual central tendency, and being likely to return to that mean, this deviation then becomes an opportunity to trade against the trend. As always, trading against the trend is dangerous and requires close stops, but the reversion also provides an opportunity to position with the trend when it occurs. When price action continues to move away from the Moving average in a climatic way, they are often signaling that the trend is changing direction. Have a look at crude oil chart below.
A moving average is a constant period average, usually of prices, that is calculated for each successive chart period interval. The result, when plotted on a price chart, shows a smooth line representing the successive, average prices. Moving averages reduces the effects of short-term oscillations. Many successful Price action traders use moving averages to determine when trends are changing direction. Moving averages are especially useful if applied in a proper way along with price action trading.
How to use Moving Averages to Determine Price Action
Moving averages are commonly used technical indicators often used in trend trading strategies. We specifically say ‘trend trading’ strategies because they lose some of their utility in a sideways market when prices closing within tight ranges causes it to be in close proximity of price itself, leading to an increased number of fake signals due to the price repeatedly touching the moving average.
It is also fairly common for traders to be using more than one moving average, often a combination of slow and fast moving averages. In this article, we take that approach and spin it in a slightly different way to give you a fresh perspective relating to the use of moving averages in your trading.
- Also Read: What is Trading Account? Must Know
Moving Averages and Price Action – The Constriction Principle
The basic purpose behind using a shorter period moving average with a longer one is simple. The trader is looking for both perspectives in making a more informed decision. While a shorter term moving average will be pegged more closely to price resulting in more touches (and perhaps trading signals), the long-term moving average gets touched less frequently during a normal trending market, and is frequently used as a target in trading systems – or in some cases even a signal for trend reversal when the long and short-term moving averages cross over.
There exists, however, a different perspective to following the simultaneous patterns of slow and fast moving averages in relation to price action and we call it the constriction principle. This principle would generally apply to most combinations of slow and fast moving averages, but in this article, we attempt to find the critical point for the 21 and the 50 exponential moving averages (EMA) interaction where traders can determine a price direction.
The constriction principle is a derivation of the much popular Bollinger bands indicator. This principle emphasizes not on the moving averages crossing over, but rather the distance between the two moving averages as an indication of the strength of the trend.
When in a strong trend, the price will pull the 21 EMA with it which in turn will diverge further away from the 50 EMA, causing a larger gap between the two moving averages. As price pulls back, or transitions into a sideways pattern, the moving averages will close in together, often creating a ‘constriction’ that usually works like the tightening of a spring and its eventual release. That is, the price will often bounce right off the constriction zone, or breakout into a trend – as the case maybe.
If you recall, we said the constriction principle is a derivation of the Bollinger Bands indicator. Note that Bollinger Bands also measure market volatility and will expand or contract given the tick activity in the market.
Past performance is not indicative of future results.
The chart above illustrates how the two EMAs behave when the market is strongly trending. We have above a dominant downtrend displaying frequent but short pullbacks. Notice how the distance between the two EMAs is fairly consistent to reflect the smoothness and consistency of the trend itself.
When the market does pull back, it bounces fairly accurately off the 21 EMA – a phenomenon we notice is very common during strongly trending conditions.
You should also notice that towards the bottom right we have an extended pullback. Notice the behavior of the moving averages. We have here what we call the ‘constriction’ of the EMAs caused by an extended pullback into the downtrend. Essentially, the 21 EMA gets pulled back up with the price to close in on the 50 EMA tightening or constricting the gap between the EMAs. If the trend is strong enough, and other factors permit for the trend to continue (for example the lack of any clear and evident support areas underneath for this case), we can expect this coiling up of the EMAs to swiftly release price back in the direction of the trend.
Note, however, that like all technical indicators, moving averages too are lagging in nature, which means that they react to price rather than price reacting to them. That also means that the constriction of the EMAs itself isn’t the cause of the resumption of the downtrend, but is rather an effect of price resuming the trend. Like with all technical indicators, eyeing the constriction phenomena will help you read price action because of the visual cues.
We’ll illustrate with an example to clarify the above point.
Past performance is not indicative of future results.
We’re looking at an uptrend that slowly transitions into sideways market action. Each of the pullbacks into the uptrend cause a slight constriction of the EMAs, resulting in price shooting back up sharply. But as we approach potential key resistance around the 1.200 crucial round numbers, an extended pullback does NOT result in price shooting back up sharply. You should note that as price tried to resume the trend after the last pullback, it stalled at the crossover point of the two EMAs and actually reversed back down. This is usually a very strong indication that we are either entering a period of elongated sideways action, preparing for a deeper pullback into the dominant trend, or entirely reversing the trend.
A major criticism of a lot of moving average based trading systems is that they often fare poorly in trying to predict upcoming broader market sentiment. In other words, moving average traders often find they do well in trending markets but will need to absorb a few losses before they eventually come to realize the market has transitioned into a range rather than a steep dominant trend.
This refined approach, however, can potentially better clarify price action. By watching how price behaves as it pulls back to a constriction zone can give you deep insights into the momentum present in the current move. Remember that upon a pullback to the constriction zone, we are actually looking for a sharp move back in the direction of the trend.
It also helps to be able to add other aspects of technical indications into your analysis. As stated above, when looking for a resumption of the trend at the constriction zone, it helps to analyze if the trend has room to proceed. Does the constriction zone also line up with a round number or a horizontal support and resistance zone? Is the trend headed into a key swing high /low? Answering these questions will help you build an overall understanding of the market while following the patterns can help give shorter term cues to fine tune your entries and exits.
On the chart above we highlighted a bullish engulfing candlestick pattern. Can you see why this could have been a very good trade? Not only do we have the constriction of the MAs and the candlestick pattern form right off the constriction zone itself, we also have a breakout play here out of the wedge pattern indicated by the two angular red lines.
As is with any profound trading methodology, your trigger should come from a singular source. Some trade setups, however, have multiple factors lining up in favor of them. Watching for constriction zones on these two EMAs is just one of those factors.
- Also Read: How To Grow Your Business Online in Trading?
Most ask Questions and Answers by Users
What is the difference between Ma and EMA?
Since EMAs place a higher weighting on recent data than on older data, they are more reactive to the latest price changes than SMAs are, which makes the results from EMAs more timely and explains why the EMA is the preferred average among many traders.
Should I use EMA or SMA?
The SMA is used to identify the longer-term trend and potential areas of support or resistance, while the shorter-term EMA, also called the signal line, will be used to identify potential changes in the trend for buying or selling opportunities.
When should you not use a moving average?
Moving Average Disadvantages
Technical analysts also use moving averages to identify potential changes in trend. For example, a "death cross" pattern happens after a stock has moved higher, begins to move lower, and the 50-day moving average crosses over the 200-day.
Which is the best moving average for day trading?
5-, 8- and 13-bar simple moving averages offer perfect inputs for day traders seeking an edge in trading the market from both the long and short sides. The moving averages also work well as filters, telling fast-fingered market players when risk is too high for intraday entries.
What is the best EMA for day trading?
Here are 4 moving averages that are particularly important for swing traders:
20 / 21 period: The 21 moving average is my preferred choice when it comes to short-term swing trading.
50 period: The 50 moving average is the standard swing-trading moving average and very popular.
Which EMA is best for intraday trading?
Generally traders want to trade in the direction of the trend to improve odds and go with the flow. The 8- and 20-day EMA tend to be the most popular time frames for day traders while the 50 and 200-day EMA are better suited for long term investors.
Is moving average a good indicator?
Key Takeaways
A moving average (MA) is a widely used technical indicator that smooths out price trends by filtering out the “noise” from random short-term price fluctuations. The most common applications of moving averages are to identify trend direction and to determine support and resistance levels.
Which technical indicator is the most accurate?
Still, personally, I feel that RSI or the relative strength index which is an oscillating momentum indicator ,is the most accurate technical indicator, not only based on its performance but also based on the user-friendly nature. RSI uses numbers to indicate the market conditions.
Know more about best moving average for daily chart visit on Wikipedia.
