In this lesson, I will show you a moving average trading strategy that will help take your trading to the next level. You probably heard of the moving average indicator. But in case you have not, let me begin by giving you a crash course about moving averages.
What Are Moving Averages?
By definition, a moving average is an indicator that helps to smooth out the price by removing the swings and fluctuations surrounding the instrument. So what you get is a smoothen outline that is easy on the eyes and tells you how price has been moving over a period of time.
In this lesson, I will show you how to use moving averages so that you can incorporate them into your trading arsenal of weapons. When used correctly, it can be very powerful in identifying trends and riding them till it bends.
Setting Up the 50-Period Exponential Moving Average Trading Strategy
So for this strategy that I’m going to be sharing with you, you will need to setup a 50-period exponential moving average. So depending on which trading platform you are using, the process of adding the indicator can be different. But the moving average is a basic indicator that most trading platforms will have anyways.
If you need a recommendation, check out Trading View. It is a web-based trading platform that is free and beginner-friendly.
Make sure you set the length to 50 in the settings for the exponential moving average indicator.
Now before I go on, I will emphasize this important point: Never use indicators on their own to analyze the markets or to trade. You have to understand the price action context then use the indicators to compliment your analysis. We only use them to confirm and support what we have already established with price action.
The above statement is really important. If taken out of context, it is the surefire way to blow your trading account. I’m not asking you to trade every single moving average bounce/break. So please don’t get me wrong. If you need a holistic method to analyze the market, check out my free day trading guide where I teach you a step by step process to analyze any chart.
You might ask why are we still using moving averages in this case? Because they are powerful indicators that are beginner-friendly.
Let me explain.
The Three Uses of Moving Averages
Moving averages can help you identify the market condition easily at a glance. This is especially powerful if you are a new trader and do not yet know how to identify market conditions. When the 50-period exponential moving average is above price, it represents a bearish market. Conversely, when the indicator is below price, it represents a bullish market. When the price is flirting around the indicator, it means that the market is in consolidation and has no direction.
Sounds simple? That’s precisely why they are beginner-friendly.
Moving averages can also help signal a possible trend reversal. When we see a breakthrough in the moving average line, that’s an early sign that the momentum has changed. Suppose we are in a downtrend and price broke through the moving average line, that is an early indication that the bearish momentum is turning and a reversal might be on the way.
The same is true for the opposite; in an uptrend and price broke through the moving average line, that is an early indication that the bullish momentum is turning and a reversal might be on the way.
The final use of moving averages (not just exponential moving averages) is as dynamic support and resistance levels. In a trending situation, moving averages can act as dynamic support and resistance levels. Suppose we are in an uptrend and price forms a nice rejection of the 50-period exponential moving average, this is an excellent sign to go long or to carry on holding your long positions. The converse is also true when we are in a downtrend and price forms a nice rejection of the 50-period exponential moving average; that’s a good sign to go short or stay short.
Please note that this only works when we are in a trending environment, so please get the price action context correct first and not simply trade every pin bar pattern off a moving average.
The Best Moving Average Trading Strategy
Let’s get to the juicy part of this lesson; actually incorporating the 50-period exponential moving average into trading. The objective of this strategy is to catch pullbacks/retracements. Let’s start by heading over to the daily time frame.
Now, we want to identify a currency/instrument that is trending. As I mentioned earlier, this is a pullback/retracement strategy. Therefore, it is mandatory to have a trend (because only in a trend are there pullbacks!).
How do you identify a trend? By seeing if the price is making a series of higher highs and higher lows for an uptrend or a series of lower lows and lower highs for a downtrend.
The next step would be to identify your area of the horizontal area of support and wait for the 50-period exponential moving average to align. Ideally, you want to have a horizontal area of support and resistance because this increases your probability. This is known as confluence in trading; where multiple indicators point to the same thing.
Think of it this way…
If more indicators point to the same conclusion, then more traders will form that conclusion. And when more traders form the same conclusion, the stronger the level.
Now let me show you an example of the confluence outlined above.
In the chart above, you can see that the previous horizontal resistance was broken and was retested. Coincidentally, the 50-period exponential moving average was aligned nicely with the horizontal support level.
Now as the price is approaching the 50-period indicator and the horizontal support level, you want to observe the price action occurring at that level before taking a trade. You do not want to blindly enter a trade or place a limit order at that level without watching price action.
You want to look for candlestick patterns that indicate a reversal at that level. A reaction at that level doesn’t equate to a trade as the price can stall at that zone before dropping further. Hence, it is important to identify reversal candlestick patterns. The candlestick pattern will also help you properly define your stop loss and provide you with an exit point if you are wrong.
If you are new and need some help identifying candlestick patterns, I have created a candlestick cheat sheet in my free day trading guide. You can use that as a reference if you need some help with that.
In the above example, I demonstrated a bullish example where you are trying to buy the retracement. The opposite is true for a bearish example where you are trying to sell the retracement.
To recap, here are the steps involved:
1. Identify the trend
2. Look for a confluence of horizontal support and resistance and indicator
3. Look for reversal candlestick patterns
I will reiterate that you never blindly buy every single bounce off the indicator. You always want to follow the steps outlined above.
So you manage to enter at a great price and you’re sitting on a handsome well deserved profit…
But when do you exit?
When it comes to exiting, there is, unfortunately, no fixed answer and as you trade, you will getting better in locking in your profits. But I will, of course, provide you with a suggestion.
A simple way to exit your trade would be to wait for price to close on the opposite side of the moving average. Since you are trading with the moving average and want are expecting price to be supported/resisted by the indicator, then it make sense to exit the trade when this expectation is no longer valid.
In conclusion, this trading strategy is effective in trading pullbacks/retracements and there must be a predominant trend. This strategy is ineffective in a range-bound scenario where price is trapped between support and resistance and the moving average is flat.
Make sure to follow the 3 steps outlined above so that you are applying this strategy correctly.