How to use Moving Averages in trading. Learn about a simple Moving Average trading strategy, to maximize your profits

Are you curious what Moving Averages are? Watch our latest video and learn how to use Moving Averages in trading and which are the two most popular ones.

How to use Moving Averages in trading – a simple, yet effective guide

Hello and welcome to Diary of a Trader. Today, we’re going to go over moving averages and identify what they are, how they work, how they should be applied to your trading and how not to use them.

So, we’re going to start with a brand new chart. This is the Aussie Dollar/US Dollar Forex pair, and if you use TradingView, and you type moving average, you can see that there is a large amount of various moving averages, and this isn’t even really a taste of, actually, it’s just a taste of the kinds of moving averages that are out there. Probably, the two most popular are the Moving Average and the EMA, or the moving average sometimes is just referred to as a simple moving average and the EMA is the Exponential Moving Average. And, if we see here, we just changed the color, we can see that they are a little different in how they’re measured. One seems to be more exact, or let’s say, one is more jerky and the other one is more smooth. But, for the purpose of this, we’ll use the EMA. The EMA is generally regarded to be a more accurate and a more honest representation of past price movement. Now, the issue with moving averages is that they are all lagging, alright? And lagging indicators only tell you what has happened. They can’t tell you what will happen. Every indicator is a lagging indicator. The only indicators that can turn into leading indicators, are things like horizontal levels of support and resistance, diagonal lines, and Gann’s market geometry, or finding divergences in certain types of oscillators. And so, one of the dangers that people find very quickly and that they get into of moving averages is new traders. New traders learn about moving averages right away, and then they learn about these things called, Moving Average Crossover Systems. And Moving Average Crossover Systems, they look a lot like this. So, we’ll get another EMA here, and they have something called, a fast and a slow. And so, let’s make this one 21 periods. And we’ll turn that red, so we know that the red line is our slow moving average and then we’ll turn the fast moving average to an 11 period moving average. We’ll turn that one green, so we know that that one is faster.

Now, one of the first things that you learn, like I said, is that a crossover system tells you that, well, when price crosses above, when the fast moving average crosses above the longer moving average, then you go long. And if price were to cross below this line, or if the fast crosses back below the slower, then you would exit. But I want to show you the danger of this because it looks like this is a good idea. You know, this looks like it’s normal and it looks like it’s very easy and this is the trap that a lot of traders get into. So, if we were to do a market replay, and let’s just go back to here. Alright, and here’s our averages so, so we’re waiting for an entry to go long or short. Now, right here is where you get into the dangers of a lot of the crossover systems, is that, if you’re looking at the moving averages and you know what? Let’s actually bring them out a little bit more. Looks like we got them out as much as we can. But, you can see that the fast did cross above the slow, and so, if you were to go long at the close, you would have gone long up here, and then look what happened to price. It fell down. You would have stayed long because you hadn’t crossed below yet, but now, look what happens. It looks like the fast EMA is crossing below the slow. So, now you would exit that trade, and then right here, because you don’t know that this has crossed yet, you would enter short here. Now, you would have had some pips, you would have had a gain here because you entered short, and you would have stayed short, and so far, that trade is more than likely working out. However, one of the rules in crossover systems is that if price crosses above, if you’re short, you’re short because the fast crossed below the longer EMA. When price crossed above this, you would have exited the trade.

And again, moving averages only tell you what has happened. It won’t tell you what will happen. Here’s another example. We see price crosses above, but we’re waiting for a crossover of the fast moving average and above the slow moving average. Happened right here. And so, this does not paint on the screen until after it happened. So, you enter on the open of the next bar, and this is where a crossover system would have you enter right here. And you would already be in a losing trade. Now, the question is always, for new traders, is, if you follow these rules, Crossover System says, just follow the rules where you only buy when the fast crosses above the low, and only short when the fast crosses below the slower. But the danger inherent in all of this is that price is choppy, price moves a lot, it does not stay always above or below these lines, because these lines are just averages. They are not to be used as specific areas of support and resistance, although they do act as that. So, on short time frames on fast-moving markets, moving averages are dangerous and they will hurt you. The best way to use a moving average is as a frame of reference. And that means not using the fast periods, but, probably, one of the most well-known ways to use a moving average is to identify over a mid-term trading range or a long-term trading range, what a market is doing and what its trend is. And people do that often by using a 200-period moving average.

So, 200 trading days is equivalent roughly to a whole year of calendar days. And so, this black EMA is the 200-day moving average. And, so this lets us know that this has been the average price throughout the year, as we’re going on the daily chart. And so, oftentimes, traders will use this as a frame of reference to say, “Well, if price is above the 200-day EMA, then that means that our market is for the most part bullish.” And if it is below the 200-day EMA, then we’re saying that this market is bearish. Now, the 200-day EMA, more than any other moving average on a daily chart, will often act as that kind of area of a support zone and a resistance zone and this level, this 200-day moving average on a daily chart is probably one of the more useful and most important levels to keep track of, as traders, and even institutions, and on Wall Street, they pay attention to the 200-day moving average. And so, this is probably the safest and most effective application of a moving average. It’s too dangerous to use on fast time frames because price whipsaws too often and new traders are too vulnerable to not being able to stay in a trade for very long. They get nervous and anxious and they enter and exit too fast. But, the 200-day moving average, as a frame of reference to decide whether your trading should be biased as a long or a short this is probably the safest and most effective application of that moving average.

Hope you found this video useful. I look forward to talking with you in our other videos. Bye-bye.