Moving Averages in Action In a past post, we looked at how you can possibly use Bollinger bands within your trading. So, if you haven’t already read it and would like to, please look at our past posts for details.
Today, we want to cover moving averages, which is another trending indicator. Trending indicators are important because they allow us to confirm activity currently being seen in price action. This can provide extra confidence in the trending condition of an asset.
So, let’s look at simple moving averages.
These are used to confirm the current trend of a market. They smooth out price action and can be calculated over various time periods.
For example, a simple 5 day moving average is calculated by adding up the previous 5 closing levels for an instrument, and the total is divided by 5. This is recalculated the next day using the latest 5 closing levels and the new total is again divided by 5. The resulting line is plotted on a price chart.
As prices move higher, the moving average will move higher following below price activity. As prices decline, the moving average will fall above price.
This effectively shows us the 5 day price trend of any instrument.
Using this type of calculation means the longer the timeframe, the slower a moving average reacts to price activity, be it up or down. For instance, a 5 day moving average will follow price action more quickly and closely than a 50 day moving average.
You can have as many moving averages on a chart as you wish, but be aware, the more you have, the more confusing reading the chart can become.
As such, we are going to be looking at examples below, using just 2 simple moving averages, because the relationship between the 2 averages throws up some potentially interesting signals.
Combining 2 Moving Averages on a Pepperstone Price Chart:
As already said above, if a 5 day simple moving average is rising, it reflects the 5 day trend is up. If we expand on that, we could say, if we are using 2 moving averages, like for example, the 5 and 10 day averages, if both are rising or falling at the same time, it potentially offers a stronger indication of the trending condition of an instrument.
Using this combination of 5 and 10 day averages, let’s look at a daily chart of the Germany 40 index on the Pepperstone system.
In this chart of the Germany 40 index, with what we already know about moving averages we can say, if both the 5 and 10 day averages are rising, the Germany 40 index is trading within an uptrend.
If they are both falling, the price of the Germany 40 index is in a downtrend.
As such, simple moving averages can offer a way to assess the trending condition of an asset. However, it doesn’t stop there.
Look at the times marked by the chart above, where the rising 5 day average, crosses above the rising 10 day average. These signals are marked by green arrows and can materialise during the early stages of a new upside move.
When a cross is seen where both the 5 and 10 day averages are rising, it is called a Golden Cross, which may see further price strength.
Now look at this chart.
Look at the crosses in the averages where the falling 5 day average crossed below the falling 10 day average, marked by red arrows.
These may be seen before the early stages of a new downside move.
When a cross is seen where both averages are falling, it’s known as a Dead Cross, which could see price weakness.
To Stress, the Averages Must be Moving in the Same Direction When They Cross.
If they cross but are moving in opposite directions, this can be a neutral signal and tends to suggest sideways/consolidation activity in price.
When this is seen, its important to wait for confirmation of the trend. This would be indicated by price breaking higher for an uptrend or lower for a downtrend, followed by both averages then starting to move in the same direction again.
At this point, we should say because of their calculation, moving averages do give lagging signals. In other words, ‘Price has to move to move a moving average’
So, you will see in both the Golden and Dead cross examples on the charts above, they come after either price strength or weakness has already developed.
However, while lagging in nature, moving averages give confirmation of a trend. This can highlight the potential of a move in price, in the direction of the moving average cross.
Being aware of the Golden and Dead crosses can be useful in highlighting possible trending conditions and when you may want to trade with the trend. This can provide you with more confidence that you could be active within a trending market, although this would depend on future price action.
Another Use of a Moving Average is to Highlight a Support and Resistance Level Within a Trend.
Let’s take a look at the daily chart of the Germany 40 index, but this time just using the 5 day moving average.
Notice, that when a correction is seen and prices sell-off but are still within the uptrend, it’s the rising 5 day average that can mark a support level, marked by the green arrows.
This may in turn see upside moves resume to continue the uptrend, with prices possibly breaking the previous high or resistance level to extend the uptrend.
Within a downtrend, the opposite is true.
A rally within a downtrend may find resistance at the declining 5 day moving average, from which price weakness is resumed to potentially extend the on-going downtrend, marked by the red arrows on the chart above.
So, this approach can be used in several ways to assist us when trading.
For instance, if we are positive of an instrument, within what may be suggested is an uptrend, but don’t yet have a position, we could view corrections back to the rising 5 day average as a move back to support.
Or, if we’re negative, but don’t yet have a position within a downtrend, a rally back to a declining 5 day moving average, may offer an opportunity at a higher level, as it could act as a resistance level, although this is not guaranteed.
Stop losses on long positions could also be placed just under a 5 day moving average, while stop losses on short positions could be placed just above a 5 day moving average. As moving average breaks may see a more extended move in the direction of that break. This may provide protection against possible adverse price movement.
A big advantage of this method of stop placement, is the stop loss moves or trails behind a rising average in an uptrend, or a declining average within a downtrend. This means when long in an uptrend, the stop follows prices higher. Or if short in a downtrend, the stop loss follows prices lower.
Observing Moving Averages in Real Time:
The Germany 40 index is likely to be in focus today with the ECB Interest rate decision released at 1315 GMT and then the ECB Press conference starting at 1345.
Market expectations are for the ECB to cut rates by 25bps (0.25%), so anything else is likely to be a big surprise. However, could they cut by 50bps (0.5%) to try and give a major boost to the Eurozone economy?
After the announcement of the rate decision, Madame Lagarde’s comments in the press conference will also be important for the direction of the Germany 40. Will she confirm more interest rate cuts are a real possibility during the first quarter of 2025, or will she be more guarded, emphasising concerns about a potential resurgence of inflation?
Whatever the outcome of these events, the Germany 40 may be more volatile than usual, so you can observe how these moving averages perform in real time.
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