7 steps to trading moving averages

7 Steps to Trading With Moving Averages

Moving averages are one of the most widely used and easiest to understand tools in trading.  Check Wikipedia's article on moving averages for a brief rundown of the different types of moving averages that are used.  For our purposes we will use Wiki's definition of a simple moving average, which is the unweighted mean of the previous n data points. 

1. Identify your favorite time frame.  The two most popular timeframes for unweighted moving averages are 200-day and 50-day.  The 200-day average gives traders the mean of the close of the last 200 trading days, and the 50-day average deals with the last 50 days. 

2. Identify major points of support and resistance.  Support and resistance are two of the oldest concepts in technical trading, and moving averages give traders a time-based, linear visualization of those actual points.  If the stock price is riding above a moving average, then the average becomes a technical point of support for the price, and if the price is below the moving average, that level becomes a point of resistance.  When price crosses over a moving average, support becomes resistance and resistance becomes support.  These levels are important because the stock needs huge momentum to break through its respective levels of support or resistance, and could not break through without pressure from traders.  Any trader making a trade should know where the moving averages are for the stock they are trading.

3. Identify the long-term trend using the 200-day moving average.  The 200-day average shows a long-term, broad pattern.  By using just this indicator, traders are given an extreme advantage, because the long term trend is clearly and visibly shown.  A quick and easy rule for traders would be to only buy stocks that are above their 200-day and to only short stocks that are below their 200-day.  If the 200-day moving average is showing plainly the direction and movement of a stock over the past 200 days, why would anyone want to fight against that momentum?   

4. Identify the medium-term trend using the 50-day moving average.  The 50-day moving average differs from the 200-day in scope, and the resulting average gives a different, obviously shorter view.  One of the main differences between the 50-day and the 200-day is the strength of the support/resistance provided.  Because a 50-day average has fewer data points to work with, the strength of the support/resistance will be much less than the 200-day.  It is much easier for a stock to break through an average with fewer days in the equation because there is less data to back it up.

5.  Always check the next longer time frame before you trade, and use the same moving averages on both charts.  So, if you trade intraday charts with a 20 simple moving average and 50 simple moving average,  check the daily chart using the daily 20 simple moving average and 50 simple moving average. A swing trader trading daily charts should always check the weekly chart.  Often this will help you avoid stepping into a trade before the corrective move is completed.  A swing trader who is ready to step into a trade may see that the weekly chart is actually showing significant moving average support a little lower than the daily charts are suggesting.  Many times this helps avoid getting stopped out of the position.

6. Create your own moving average combinations.  Over the years traders have created infinite combinations of moving averages, using them to identify key breakout levels.  Moving averages can be used in all time frames, and by using multiple time frames and moving averages, traders gain a huge advantage in determining levels of support and resistance, which can then be used to time large breakouts.  One thing that traders should avoid is overdoing it.  Having a good combination of moving averages can be extremely helpful, but don't get too bogged down in trying to create the perfect one.  Play with different time frames and find the ones that fit your style the best and that you can believe in. 

7.  Check out Dave Landry’s work.  Dave has used moving averages extensively in his work for a number of years, and he has developed a number of very successful strategies that employ moving averages.  When it comes to moving averages, no one does it better than Dave.  Here are a few articles by Dave.