Moving averages are one of the most popular indicators amongst traders of any financial markets. They intend to figure out the direction of a trend by taking the average closing price of a financial instrument over a period of time.
The question however remains that; how critical is the purpose of moving averages and do you really need them to succeed as a trader? All technical indicators complement price action by adding additional information. Moving averages overlay charts and by so doing, may clutter your screen.
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Moving averages come in two forms; the simple moving average and the exponential moving average. The simple one takes the average closing price of a financial instrument over a specified period of time. The exponential one does the same thing, but it puts more emphasis on the closing prices of the most recent days.
There is also the smoothed and linear weighted moving averages but the two above are the most popular amongst traders.
Price action is the ultimate and it is a better alternative to this technical indicator as I will demonstrate to you below. One huge disadvantage of moving averages is that they lag; this means that they will give you a signal only after the big moves have taken place.
Moving averages for trend direction.
It is as simple as ABC. When candlesticks are above the moving average, this is indicative of an uptrend. The opposite is true; when candlesticks are below the moving average, it shows that the market is in a downtrend.
But then, do you really need these squiggly lines to show you the direction of the market? It’s an obvious NO. You only need your eyes to figure out where the market is headed coupled with a knowledge of market structure.
In live market conditions, price action may go above and below the moving average so many times that it may lead you to many mistakes if you solely depend on it to find trend direction.
An uptrend is made up of higher highs and higher lows whereas a downtrend is made up of lower lows and lower highs. This is basically all the knowledge of market structures you need to have in order to determine trend direction. Adding this technical indicator may serve as grounds for confusion.
Trendlines do the job better:
This is a 20 day moving average applied to a commodity that is in an uptrend. For the most part the price action is above the indicator so this indicates and uptrend. The most recent price action also shows that the price action is above the indicator so looking for buy opportunities will be the best option. This however may not be the best way to look at it since price is far gone already. Areas on this chart where the price action went below the moving average are indicative of minor downtrends or pullbacks against the main uptrend.
The better alternative for using this technical indicator for trend direction is to use trendlines. Notice how the trendline has promptly captured the higher lows of this uptrend. Where a trendline cannot be plotted is indicative of no trend or a consolidation. Using this trendline as a case, you can clearly see that the market has moved too high to buy; the best way to buy is to wait for another probable test of the trendline.
Moving averages for trend change.
Moving average crossover is a concept that enables traders to take advantage of changes in trend direction. In instances like this, two moving averages are plotted on a single chart and whenever they intersect, the idea is that the trend has changed.
With the two moving averages, one is fast and one is slow. This is to mitigate the lagging nature of this indicator to find a balance.
In a perfect world the moving average crossover concept would be a very ultimate tool for traders but it obviously is not so. Crossing over means you can jump into a trade on trend change or you can exit a trade you are in already because of the change in trend direction.
The fact that this technical indicator lags makes the whole idea of catching change in trend direction kind of pointless. By the time two moving averages intersect each other, the price action from the timed candlestick would have already occurred.
Would you rather rely on the raw price action which lays everything bare or you would rely on this technical indicator; that relies on the raw price action to give you the info on what is happening on the charts.
The best way to figure out change in trend direction is to rely on simple concepts like; the breakout of a trendline to the opposite side or the breakout of various market structures for first hand info. Moving averages can only be used as confirmations.
Breakouts do the job well:
On this chart you can actually see that whenever the moving averages crossed over the trend changed. There is a 10 day moving average(fast) and a 20 day(slow) one. Looking at this from price action that has happened already looks good on paper but in live market conditions; the candlestick would form before the moving average crosses over (lagging). Also if you solely depended on this, you would definitely overtrade since the signals would be coming every now and then.
Using a simple price action alternative like a market structure breakout; you would be patient enough to wait for an ultimate signal rather than getting many signals which may leave you confused. The breakout of this uptrend line indicated the trend change simply; the blue-arrowed candlestick would have afforded you the opportunity of an early entry. This leaves out confusion and second guessing.
Moving averages for dynamic support and resistance.
The concept of support and resistance seems to be the basis of the technical analysis of the financial markets. Moving averages can also be used in place of lines to find these very important levels in place of the simple lines.
As the price action changes, the moving average also resets itself to follow through capturing the support and resistance; that is why it is referred to as a dynamic one. This may look like a positive use of the moving average but then, it is not very ideal.
Using this technical indicator in place of support and resistance levels may be disastrous. This is due to the dynamic nature of it and how frequent it may be. I don’t know much about you; but I would like my support and resistance levels to be static for a while until I have been convinced otherwise.
It is better to stick to support and resistance levels that make use of lines; than this technical indicator which may be an author of confusion.
This chart has the 200 day period moving average that has acted as support twice and resistance four times. As you already know, this changes with each candlestick formation, therefore, simple lines would do an ultimate job. With the test of the resistance level, you can see how inaccurate they can be.
Simple lines do a better job with the plotting of support and resistance than moving averages.
Final thoughts on this technical indicator.
Moving averages as well as many technical indicators should not be depended on solely. This is because they give a lot of false signals.
Also as you can see from the charts, all the moving averages have their own settings in terms of days; there is the 10, 20 and 200 day period moving averages. This setting is very subjective and there may never be a right or wrong one but the one which works for you.
As demonstrated above, this tool could be avoided completely with a solid knowledge base in price action. If you cannot avoid it too, you should only use it to complement price action.
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