When it comes to determine trends in a market, one of the most talked about indicators is the Moving Average (MA).
Trend is your friend
You must have heard about one of the most popular, yet powerful things in the markets.
If you follow the markets, you must have come across a lot of news releases or technical articles, or even traders on social media sharing some technical things like:
"Bitcoin is currently trading over the 200 MA"/"Bitcoin is making a death cross"/"Bitcoin is making a golden cross"/"Bullish/Bearish Moving average crossover between 50MA and 100MA on Bitcoin" and so on.
It can be anything, there can be a lot of permutations and combinations based on moving averages, but what does that mean and how to use it?
If you are still thinking, you might have come to the right place :)
So let's have a deep dive into the first trend following indicator!
Disclaimer: I'm not a certified financial advisor, and even though I've been trading for quite a few years, I urge people reading this, and my other posts to #DYOR (Do your own research) before taking any decisions! There is no guarantee whatsoever that you will become a profitable trader.
The purpose of this article is for educational purposes. It is completely up to you how you want to trade in the markets, and there is no holy grail that will guarantee you profits of an kind solely based on the indicators/patterns.
Of course I'm going to help you out if you have some queries/doubts, so feel free to let me know in the comments, or on Twitter :)
Before we move on to a particular type of trend indicator, we should first understand how many types of trend indicators are there and what are those
The different trend indicators include:
- Moving averages (Includes all types of Moving averages, like Simple, exponential, weighted and so on)
- Moving Average Convergence Divergence (MACD)
- Trix Indicator,
- Supertrend Indicator,
- Ichimoku Indicator
- OBV (Can be used for trading trends)
- RSI (Can be used for trading trends)
- Parabolic SAR
- Guppy
(There can be other indicators, but our goal is to not go through all of them to gain knowledge, but to gain an understanding behind how they work.)
Let's focus on Moving averages first:
What is a moving average?
When we think of the word "Average", we simply calculate it in the following way:
- Take the sum of all quantities,
- Divide it by the total number of units.
It's easy right?
In simple terms = think of it as:
Average = (A1 + A2 + A3 + A4 + ...... An)/n
Where A = anything (it can be price)
1,2,3,4,....n = number of data points. Here, n is the total number of data points, so we are calculating it that way.
Now what is a moving average?
A Moving Average is = The sum of last n close prices divided by the number n.
That is the most simple definition of a simple moving average, where n can be the time period.
Now if you are having background in pure mathematics/statistics, you may argue that it is not exactly an average, but it's more like an Arithmetic Mean.
So that is completely true. But for simplicity, let's not dive that deep :)
(Reference: https://www.investopedia.com/terms/m/movingaverage.asp)
Now let's have a visual representation in charts:
Similarly, here's a Do it yourself:
Open your favorite chart, and try opening the 30 MA, and 50 MA for example, on the daily timeframe.
So why are we really interested in these mathematical stuff?
- It summarizes the data
- It gives accurate average data about a large amount of data.
Two things we need to consider while calculating moving averages:
- Timeframe (1 day, 4 hour, 5 minute, etc)
- Time period (50 MA, 100 MA, 150 MA, etc)
So if someone tells you a certain asset is trading over 50 MA, stop. Ask which timeframe it is.
That should be more helpful!
Example: a 4H 50 MA and a 12 hour 50 MA will be completely different. (I used to get confused when I was a noob trader, some years back :P)
So what happens if we change the variables?
Let's have a look at the 1D 50 MA now:
If you observe here, the data has more lag, as it considered a much larger amount of data points, which makes it more significant.
Here, the calculation can be done in the same way, like the 9MA, but here, instead of the last 9 data points, we are actually taking 50 data points (or last 50 close prices)
Similarly, in a 200 MA, we take the last 200 candle close prices.
Let's consider another perspective:
Consider 10MA: here, each candle will move the average price by 10% (there are 10 candles)
and 100MA:here, each candle will move the average price by 15 (there are 100 candles)
I can move on to the Exponential moving averages and take a deep dive, but I'll leave that to my next article.
Let's see how we can form strategies based on moving averages, and what to do with it.
When it comes to forming strategies based on moving averages, a very solid use case is the moving average crossovers. That is the most basic and powerful thing.
A moving-average crossover occurs when, on plotting two moving averages each based on different degrees of smoothing, the traces of these moving averages cross.
Let's consider two moving averages:
- A slower moving average (example: 200 MA)
- A faster moving average (example: 50 MA)
When the 50 MA crosses over the 200 MA on a particular timeframe, we can be confirmed that the trend has changed to bullish.
When the 50 MA crosses below the 200 MA on a particular timeframe, we can be confirmed that the trend has changed to bearish.
Simple right?
Let's take a look:
There have been two moving average crosses on the daily timeframe between 50 and 200 MA, but if you look closely, in the first bearish case:
If you took short on the cross, you would have almost shorted the bottom (and considering that most people were in panic mode, everyone would have shorted, which again justifies the massive amounts of short liquidations, which built up the buy back pressure, which changed the price back to the bullish territory. So the second bullish cross was actually a good buy signal, which resulted in a decent 40-45% run and is still a valid signal, but it's not a good entry now I'd say.
Although moving average crosses can show us trends, we must remember a few things:
- We should understand that it is still a lagging indicator, which means, it relies heavily on past data that has already occurred in the markets. which is the reason we may get false positives (Like the one false bearish cross during march crash.)
- We should use other forms of analysis as well, with moving average strategies for higher probability of winning a trade.
- If the moving averages are further apart from each other, it will indicate a stronger trend.
- If you see moving averages crossing one another in very short period of time, it is not a clear trend, and it will indicate a sideways market. This is where a lot of traders get burnt trying to time the market, thinking that they will catch a trend. So multiple crosses in quick succession does not indicate a clear trend and should be avoided always.
Also remember as I told in my previous article in the series:
There can be trends within trends, so you should also take these things into consideration.
Here's one more scenario which will come from experience. If you can spot a trend change early, it's better to take position early and exit the position when you feel that the trend is maxing out.
Even though textbook definition says that you should buy the trend and follow the trend, it's not always a good idea, especially if the markets move in extreme directions. There are many people who join the trend late, and ultimately end up losing a lot of money. this is the reason why you should try to spot a trend early and hop on, instead of FOMOing into it later on once there is a very strong trend and a huge spike up (think about the opposite of the March crash?)
At the same time, if you see a bearish cross during a very bullish phase, or a bullish cross during a very bearish phase, they may signify trend reversals.
Have a look at the Trendline Series I published, and this will be your task to identify and match how the trend is evolving over time, by comparing the higher highs, lower highs, higher lows and lower lows ;)
Moving averages as price supports and resistances:
As in my previous article, we usually wait for a retest after a breakout, here also we should ideally wait for the same before jumping in.
(Remember: Prices always return to the mean)
We can use the moving average zones as areas of supports and resistances.
Have a look at the previous chart:
If you observe, the 50MA acted as support till it broke below 11300 on a large red candle around Sep.
But I'd personally recommend against using those and would instead recommend you to use them as buy/stoploss (set them below) zones.
This is because, they give out a lot of false positives and fakeouts, and chances are, you may end up losing money.
They do hold during a stronger trend, but I'd recommend using them as confirmation, again.
I hope this article somewhat helped you gain some knowledge in understanding the basics of Moving averages.
I'd cover more and dive deeper into other indicators and how to use them, along with some advanced strategies in my next articles.
If you liked the article, please this with your friends and circles, and also spare an upvote for me, so that I get motivated to keep sharing market insights and analysis :)
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