How To Profit From Moving Averages
Want to know how to make money from one of the simplest trading indicators? In this article we’ll discuss moving averages and how you can use them to generate profit.
There are many, many technical indicators available today supported by complex mathematics and theories. Today, I want to go right back to basics, and talk about the simplest indicator in technical analysis. It’s one that forms the backbone of many, many other trading strategies and technical indicators.
That’s right, it’s moving averages.
What are simple moving averages?
Wikipedia defines a moving average as:
“A moving average (rolling average or running average) is a calculation to analyze data points by creating series of averages of different subsets of the full data set”
It’s the mean of a subset of values in a series. In trading, it’s usually a subset of closing prices.
To fully define a moving average, we need to know how big that subset is. You’ll often hear people talk about the 50-day moving average, and the 200-day moving average. These are 2 commonly watched moving averages.
The “50-day” and “200-day” part means that the average is calculated from the closing prices of the previous 50 and 200 days, respectively.
Moving averages with larger subsets are generally less-sensitive to daily price changes that MAs with smaller subsets. That’s because as the subset gets larger, each single day has an increasingly smaller impact on the mean.
In larger sets, the mean is less affected by a single result. You’ll see this in the smoothness of the moving average.
You can see from the image above that the 50-day MA changes direction more frequently than the 200-day MA.
How can you profit from them?
The simplest strategy involving MAs is the MA-crossover.
When the price crosses over the MA, say 50-day MA, from bottom-up, you buy. And when the prices crosses the 50-MA from top-down, you sell.
When the price goes above the MA it suggests that the price might continue to rise, and when it drops below the MA, the converse is true. The price might continue to fall.
I’m not saying this is a profitable strategy, but it is a strategy that you should be aware of. The 50-MA crossover strategy above made about 11% over the course of 3-years…
The second strategy is a mean reversion strategy. Remember, the MA is just the mean of a subset of closing prices from a given period of time.
When the price rises a certain percentage above the MA, you sell. Because you expect the price to revert to the mean. The MA represents the mean of prices over a given period of time, so if it’s above the MA, by some margin, then you can expect the price to return to the average, i.e. revert to the mean.
The opposite is true when the price is some margin below the MA. You can expect the price to revert to the mean, and rise up, so you buy at this point.
Again, this might not be a particularly profitable strategy, but it is worth knowing. Why not try it out in TradingView and see what the results are?
The third simple strategy that I want to share with you is the dual-moving average crossover.
When you have 2 MAs on your chart, say a 50-MA and 200-MA, watch out for the MAs crossing over each other.
If the 50-MA is above the 200-MA, we’re in an uptrend. When the 50-MA is below the 200-MA we’re in a downtrend.
You should aim to buy when the shorter MA (i.e. 50-MA) crosses over the longer MA (i.e. 200-MA) from bottom-up, and sell when the shorter MA crosse over the longer MA from top-down. The crossover indicates that the trend has changed and switched direction.
These 3 strategies are very easy to implement, and are often used as examples in trading software. So they’re not particularly useful out-of-the-box. But I believe you can optimize the parameters and get some reasonable returns from them through experimentation.
Exponential moving averages
One of the pitfalls associated with simple moving averages is that they’re significantly impacted by large changes in price. They can react very quickly to negative (or positive!) price spikes.
These spikes may just be anomalies, noise, and a distraction from what’s really happening in the market.
Exponential moving averages (EMAs) provide a solution to this problem!
EMAs put more emphasis on recent prices, and react much faster to price changes. Take a look at this chart:
The EMA follows recent price changes much more closely than the SMA. This is both the EMAs curse and superpower.
EMAs can help you to identify trend changes more quickly than SMAs, getting you into trends earlier, so you can make more money. BUT they’re also much more prone to fakeouts. You might get in TOO early, before the trend has been confirmed, so there’s more chance the a small breakout will reverse.
SMAs on the other hand are much less responsive, so are not as prone to fakeouts, therefore getting you into a trend later when it’s been confirmed. This means you stand to make less money from the trade if the trend plays out, but there’s a higher chance that the trend will actually play out and not just fakeout.
“Simplicity is the ultimate sophistication” — Leonardo da Vinci
In summary, moving averages are a brilliant tool to have in your trading toolkit, but they’re unlikely to make you much money in the long run by themselves.
Moving averages are best used to confirm market conditions, rather than for timing your market entry.
Simple moving averages are susceptible to dramatic price moves, but also tend to give a better indication of the long-term trend then exponential moving averages.
Exponential moving averages can help you to identify a trend earlier, and get in earlier, but they’re also prone to fakeouts. So if you’re going to use EMAs, you should have good risk management practices in place to prevent racking up too many losses.
Don’t underestimate the power of the simplest tools.
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DISCLAIMER:The information in this article is provided for educational purposes only. I am not a financial advisor and this article does not contain financial advice. Make your own decisions about risk, or consultant a professional financial advisor.