Moving Averages as the Basis of Indicator Analysis

Welcome to the first lesson on the indicator trading and the moving average indicator, in particular. If you are reading this article by accident, I am happy to tell you that I write my lessons for online trading and express my thoughts on the themes I find important for one to become a trader. This article, as well as the others, is not devoted only to a single topic, which is the moving average in this case. You can find information about the indicators’ structures on the cheesy websites written by authors copying one another.

I would like to explain the work of the technical indicators through the moving averages as an example. I am going to specify its pluses and minuses and show how traders may use specific tools to improve their trading performance.

I think you have already guessed by the title that the line is meant to be drawn through the middle points of the bars’ values. If you want to put the indicator over the chart, open the “Indicators” tab in the top menu. Click Tools, then click Trend and then click Moving Average.

The line will appear on the chart.

You can easily find a huge amount of screenshots of traders’ workplaces. No matter whether they work in investment companies or banks, their charts are always filled with various lines and guides. I am sure you will find the moving averages among those lines.

Why Would You Use the Moving Average Indicator?

You need to understand that the moving average is a statistical tool, which just creates a middle-values line. You can do this on your own. Take the last ten candlesticks on the chart and draw an imaginary line through its middle points. The indicator does this work within the accuracy of one pip and it can take into account any amount of the bars and allow you to calculate the price in several ways.

Anyone who teaches how to trade (woe be to them all!) will show you the strategy based on the Simple Moving Average, which look something like this:

You put with a period of 24 (or any other) on the MA chart.

When the line goes bottom-up on the chart, we should buy it.

When the line goes top-down on the chart, we should sell.

Do you believe that this strategy works and that you will make good money? I am afraid you are wrong.

Yes, the strategy looks extremely simple. Moreover, it is very easy to make an algorithm out of it and start creating robot-traders and advisors. The difficulty is all about the period.

Build the MA with a period of 24 hours on the one-hour chart and analyze whether this strategy would have brought you a profit over the last month. If it does not, try any other period (36, 50, 100 or any other number).

Attention! It is important to test the indicator strategies only in the strategy tester. I shall explain why in the next paragraph.

Conclusion: the traders use the MA like support and resistance lines.

Drawing and Redrawing the Moving Average

You can find three main moving average types in the MetaTrader platform and other popular trading platforms.

Simple Moving Average (SMA)

It is quite easy to draw the Simple Moving Average. You should take the settling price and divide it by the amount of the bars. You decide which price you need to calculate:

1. Opening price
2. Closing price
3. High
4. Low

There are several derivatives of these four points. The most popular one is the median price, which is calculated according to the formula High+Low/2. This calculation is used in the popular indicator based on the MA Alligator, which we will talk about later.

The most popular method among traders is the method of calculation for closing prices. I adhere to this method too. I believe you might use other prices only for comparison’s sake. For instance, in case you are building three moving lines at the closing prices, high, and low. Once again, I have no idea how to use it in trading but maybe you have some thoughts about it.

Exponential Moving Average (EMA)

Unlike with the SMA that equally perceives the prices of all the bars, the EMA gets a larger weighting last, that is, it expands the weighting exponentially. If we create the EMA on twenty bars, bar #1 will have the lowest weighting, while the bar #20 will have the largest weighting.

“Why you would need that?” you may ask me. “To be faster,” I will tell you. The EMA is reacting to the price change extremely quickly. You can see it for yourself if you put together all four types of moving averages and pay attention to how they act while the price is changing rapidly.

Smoothed Moving Average (Smoothed MA)

I must admit that traders rarely use the smoothed and the linear weighted moving averages not least because of the unclear calculation formula.

Linear Weighted Moving Average (Linear Weighted MA)

The linear weighted moving average and the EMA have a very similar logic: they set the greatest values to the last bars. The difference between these MAs is the method of calculation. In the case of LWMA, the closing price of each bar is multiplied by the order number in the bars row of the specified range.

For example, if we set the LWMA period of 20, the price of the first bar will be multiplied by one, the price of the second bar will be multiplied by two, the price of the fifth bar will be multiplied by five, and the price of the twentieth bar will be multiplied by twenty. Thus, LWMA reacts much faster to the price change.

Why Would You Need to Shift the Moving Average Lines?

When you were setting the moving average period, you may have noticed the “Shift” field. If you set a value to this box, you can shift the indicator horizontally by any amount of bars. Why would you need to do that?

You may need that to fit the indicator.

While testing the indicator in the real market conditions, you may see that sometimes shadows of the candlesticks touch the line and make you open some excessive transactions that only bring losses. Shifting the line by one or two bars may significantly improve the whole situation. You will get the leading indicator that will display statistics for the same period you specified but will provide you with different signals to open positions.

Which MA Period Should You Pick?

If you find the right answer to this question, you can be sure that you will have the Holy Grail in your hands and earn all of the money in the world. You will have to test different MA periods, different combinations of the lines, combinations of the moving averages with other indicators, and analysis methods on your own.

I have found different parameters in different sources, and the periods of 8, 21, 50, or 100 are the most widely used.

As for me, I always try to lock the period to certain fixed time intervals, depending on the timeframe that I trade.

For example, if I analyze the H1 timeframe, I shall start with the period of 24, since we have twenty-four hours a day or twenty-four one-hour bars. If I analyze the D1 timeframe, I can take the period of 22, since we have twenty-two trading (working) days in a month and so on.

You can change the period or shift the indicator after performing primary analysis.

If It Is So Good, Why Do Traders Still Lose Their Money?

If it were that easy, every trader would make a fortune just from the Moving Average. However, if you work with the Moving Average, you can still earn good money on the trend market.

Imagine you are making the following steps:

1. Build two SMA periods: a period of 24 (fast) and 200 (long).
2. Enter the position as soon as the fast line crosses the long one.
3. When they cross again next time, we should close the position and open the opposite one.

We will get the maximum profit by opening the position following this strategy if there is a large movement in the market. The traders following the trend strategies can get the maximum profit out of such market movements.

Let’s think about the situation, when we use this strategy and the market remains in the narrow range. What will happen? Right, we will lose our money. In the case of the flat market, the lines will now and then cross the chart and the trader will have to enter the market right before the price trend switch and consequently lose money.

Thus, the trader’s task is to timely record changes in the market from the trend phase to the flat one and vice versa. Of course, we have solutions to this problem. For instance, you can use volatility indicators such as the ATR, which is based on the Moving Averages.

The Average True Range Indicator displays the following aspects:

• Difference between the maximum current price and the previous closing price.
• Difference between the minimum current price and the previous closing price.
• Difference between the current maximum and minimum prices.

Do a test of a combination of the Moving Averages and the ATR indicator in the strategy tester mode. Pay attention to how these tools act during a sideways trend in price!

Combination of Several Moving Averages and the Alligator Indicator

The Alligator indicator is the result of experiments with the periods and shifting of the moving averages. It was invented by Bill Williams, the famous trader and the author of two bestsellers. He picked the following parameters for three SMAs:

• Periods of 13, 8, 5;
• Shifts of 8, 5, 2;
• Creation method: the median prices.

Thus, we get the long, the middle and the short lines, which Bill Williams called jaw, lips and teeth.

The entry and exit strategy for the Alligator indicator trading is similar to the trading based on several converging averages.

Crossing the MA is the signal to close the position and open the opposite one. When the lines diverge (the alligator opens its jaw), the trend goes stronger. When the alligator is closing its jaw, you should see a weakening of the trend.

As you can see, this indicator is built upon the usual settings of the moving averages chosen by a particular trader. This is a good example of how statistics can be used to build profitable trading strategies.

A trader does not have much data about the market. Few things changed in trading over the last 100 years. All that we have learned to do over this time is to convert the quotes into charts that consist of the bars and candlesticks using the computers. If Bill Williams were alive now, it wouldn’t be difficult for him to keep making money in trading.

The purpose of this lesson was to show you that any technical indicator in your trading platform is not some kind of magic, but merely a visual display of the statistics.

I think this is the end of our journey on the Moving Averages. Please, share this article on social networks and I will also be happy to answer your questions in the comments if you find it useful. I hope we shall meet at the next lesson, which will be devoted to the combination of two oscillators that serve as the basis of a large number of the trading strategies.

Key Conclusions of the Lesson

• Traders often use the moving average as the support and resistance lines.
• The indicators are redrawn whenever each new indicator (bar) appears. The longer the calculation period, the more accurate it is.
• The MA and other trading indicators are good trading tools but by no means are they suitable for sideways markets. It is hard to understand when the trending market shifts to the flat one using the indicators.

Home Assignment

Make a test of different adjustments and combinations of the MA, the Alligator and the ATR indicators in the strategy tester mode.