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Moving averages are without a doubt the most popular trading tools. Moving averages are great if you know how to use them but most traders, however, make some fatal mistakes when it comes to trading with moving averages. In this article, I show you what you need to know when it comes to choosing the type and the length of the perfect moving average and the 3 ways how to use moving averages when making trading decisions.
Step 1: What is the best moving average? EMA or SMA?
At the beginning, all traders ask the same questions, whether they should use the EMA (exponential moving average) or the SMA (simple/smoothed moving average). The differences between the two are usually subtle, but the choice of the moving average can make a big impact on your trading. Here is what you need to know:
#1 The differences between EMA and SMA
There is really only one difference when it comes to EMA vs. SMA and it’s speed. The EMA moves much faster and it changes its direction earlier than the SMA. The EMA gives more weight to the most recent price action which means that when price changes direction, the EMA recognizes this sooner, while the SMA takes longer to turn when price turns.
#2 Pros and cons – EMA vs SMA
There is no better or worse when it comes to EMA vs. SMA. The pros of the EMA are also its cons – let me explain what this means:
The EMA reacts faster when the price is changing direction, but this also means that the EMA is also more vulnerable when it comes to giving wrong signals too early. For example, when price retraces lower during a rally, the EMA will start turning down immediately and it can signal a change in the direction way too early. The SMA moves much slower and it can keep you in trades longer when there are short-lived price movements and erratic behavior. But, of course, this also means that the SMA gets you in trades later than the EMA.
In the end, it comes down to what you feel comfortable with and what your trading style is (see next points). The EMA gives you more and earlier signals, but it also gives you more false and premature signals. The SMA provides less and later signals, but also less wrong signals during volatile times.
In my trading, I use an SMA because it allows me to stay in trades longer as a swing trader.
Step 2: What is the best period setting?
After choosing the type of your moving average, traders ask themselves which period setting is the right one that gives them the best signals?!
There are two parts to this answer: first, you have to choose whether you are a swing or a day trader. And secondly, you have to be clear about the purpose and why you are using moving averages in the first place. Let’s go about this now:
#2 The self-fulfilling prophecy
More than anything, moving averages “work” because they are a self-fulfilling prophecy, which means that price action respects moving averages because so many traders use them in their own trading. This raises a very important point when trading with indicators:
You have to stick to the most commonly used moving averages to get the best results. Moving averages work when a lot of traders use and act on their signals. Thus, go with the crowd and only use the popular moving averages.
#3 The best moving average periods for day-trading
When you are a short-term day trader, you need a moving average that is fast and reacts to price changes immediately. That’s why it’s usually best for day-traders to stick with EMAs in the first place.
When it comes to the period and the length, there are usually 3 specific moving averages you should think about using:
- 9 or 10 period: Very popular and extremely fast-moving. Often used as a directional filter (more later)
- 21 period: Medium-term and the most accurate moving average. Good when it comes to riding trends
- 50 period: Long-term moving average and best suited for identifying the longer-term direction
#4 The best periods for swing-trading
Swing traders have a very different approach and they typically trade on the higher time frames (4H, Daily +) and also hold trades for longer periods of time. Thus, swing-traders should first choose a SMA and also use higher period moving averages to avoid noise and premature signals. 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. During trends, price respects it so well and it also signals trend shifts.
- 50 period: The 50 moving average is the standard swing-trading moving average and very popular. Most traders use it to ride trends because it’s the ideal compromise between too short and too long term.
- 100 period: There is something about round numbers that attract traders and that definitely holds true when it comes to the 100 moving average. It works very well for support and resistance – especially on the daily and/or weekly time frame
- 200 / 250 period: The same holds true for the 200 moving average. The 250 period moving average is popular on the daily chart since it describes one year of price action (one year has roughly 250 trading days)
Step3: How to use moving averages – 3 usage examples
Now that you know about the differences between the moving averages and how to choose the right period setting, we can take a look at the 3 ways moving averages can be used to help you find trades, ride trends and exit trades in a reliable way.
#1 Trend direction and filter
Market Wizard Marty Schwartz was one of the most successful traders ever and he was a big advocate of moving averages to identify the direction of the trend. Here is what he said about them:
“The 10 day exponential moving average (EMA) is my favorite indicator to determine the major trend. I call this “red light, green light” because it is imperative in trading to remain on the correct side of a moving average to give yourself the best probability of success. When you are trading above the 10 day, you have the green light, the market is in positive mode and you should be thinking buy. Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking sell.” – Marty Schwartz
Marty Schwartz uses a fast EMA to stay on the right side of the market and to filter out trades in the wrong direction. Just this one tip can already make a huge difference in your trading when you only start trading with the trend in the right direction.
The Golden Cross and the Death Cross
But even as swing traders, you can use moving averages as directional filters. The Golden and Death Cross is a signal that happens when the 200 and 50-period moving average cross and they are mainly used on the daily charts.
In the chart below, I marked the Golden and Death cross entries. Basically, you would enter short when the 50 crosses the 200 and enter long when the 50 crosses above the 200 periods moving average. Although the screenshot only shows a limited amount of time, you can see that the moving average cross-overs can help your analysis and pick the right market direction.
#2 Support and resistance and stop placement
The second thing moving averages can help you with is support and resistance trading and also stop placement. Because of the self-fulfilling prophecy we talked about earlier, you can often see that the popular moving averages work perfectly as support and resistance levels.
Word of caution: Trend vs ranges
Moving averages don’t work in ranging markets. When price ranges back and forth between support and resistance, the moving average is usually somewhere in the middle of that range and price does not respect it that much.
The screenshot below shows a price chart with a 50 and 21 period moving average. You can see that during the range, moving averages completely lose their validity, but as soon as the price starts trending and swinging, they perfectly act as support and resistance again.
#3 Bollinger Bands and the end of a trend
The Bollinger Bands are a technical indicator based on moving averages. In the middle of the Bollinger Bands, you find the 20 periods moving average and the outer Bands measure price volatility.
During ranges, the price fluctuates around the moving average, but the outer Bands are still very important. When price touches the outer Bands during a range, it can often foreshadow the reversal in the opposite direction when it’s followed by a rejection. So, even though moving averages lose their validity during ranges, the Bollinger Bands are a great tool that still allows you to analyze price effectively.
During trends, Bollinger Bands can help you stay in trades. During a strong trend, the price usually pulls away from its moving average, but it moves close to the Outer Band. When price then breaks the moving average again, it can signal a change in direction. Furthermore, whenever you see a violation of the outer Band during a trend, it often foreshadows a retracement – however, it does NOT mean a reversal until the moving average has been broken.
You can see that moving averages are a multi-faceted tool that can be used in a variety of different ways. Once a trader understands the implications of EMA vs SMA, the importance of the self-fulfilling prophecy and how to pick the right period setting, moving averages become an important tool in a trader’s toolbox.