Wed. Oct 23rd, 2019

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How To Use Simple Moving Average In Trading

7 min read

The SMA is a versatile trading indicator that can form part of any trading strategy.  It can act as a standalone indicator or be used to find the current trend direction and forecast the type of market you may be trading.

It can also form a trading strategy of its own when you add in price action to your decision-making process.

Find The Trend Direction With SMA

This chart has four moving averages applied to it from a short term average, to a long term one.

The one you would use to determine trend direction will depend on the type of trader you are.  To determine trend direction of your chart, will you:

  1. Use the slope of the moving average as a determination of trend?
  2. Trade the direction the price is in relation to the average?  If above the average, only long trades for example.
Simple Moving Average - 10, 20, 50, 200
Simple Moving Average Example – 10, 20, 50, 200
  • The white line is the 10 SMA and will be the quickest in reaction to price.  Slope and price position signal uptrend
  • The 20 SMA is in orange and also shows uptrend.
  • The green line is the 50-period moving average and while price location shows uptrend, the slope of the moving average is down.
  • The 200 SMA is yellow and in both cases, shows a market in a downtrend

You would then use this trend determination for your particular trading strategy.

Simple Moving Average Plus Price Action Trading

Using a technical analysis approach to trading is common and many times price action plays a role in a trader’s approach to the market.

One trading strategy we can use with a single moving average combines the trend direction information of the SMA alongside common price action trading patterns such as bull and bear flags.

Markets trend, range, and mean revert and we can use the trend and mean reversion mechanics to build an outline of a trading strategy that uses everyday price occurrence.

Let’s look at how to use a single moving average for trading and in this case, we will use the 50 period simple moving average for a more intermediate trend direction.

There is nothing magical about a 50 period and there is no best period to use.  It depends on your time horizon for trading.

50 SMA - Trend Direction and Pullback Trading
50 SMA – Trend Direction and Pullback Trading

This stock chart is a good example because we have a few trend direction changes

  1. Price has come off a downtrend as price breaks the 50 SMA to the upside.  The slope of the average is sideways and the price action shows a double bottom that is a higher low being put in
  2. With permission for long trades, especially with an up-slope to the SMA, we look for standard pullback trades to the SMA.  This zone has two trades and the second one pulls back into the average plus the previous swing low
  3. Price forms a trading range but the lower shadows and subsequent basing just below resistance, points to more upside
  4. This corrective decline to the moving average is full of momentum which we don’t want to see with pullback trades.  The same area has another pullback to the 50 SMA and the previous swing low.

Price begins to break down after this but you should be able to see the upside of using price action along with the moving average as a point of reference, to take trades.

We are using a standard pullback pattern into an average price of the last 50 days.  Price mean reverts back to the 50 and we can use a variety of trade entry techniques to get into the trade.

Moving Averages – Support And Resistance

Another method used by traders is the belief that a simple moving average acts as support and resistance.

This is a myth.

There is the appearance of support or resistance but remember we are looking at a mathematical formula to calculate a moving average.  You can see a good example of the moving average “acting” as support in the above graphic at location number three.

This is a chart of crude oil using the 20 period SMA for intra-day trading.

20 Period SMA - Support and Resistance?
20 Period SMA – Support and Resistance?

The dashed white lines are showing previous price action/structure extended to the right.  You will note that when price seems to find support around the 20 SMA, it is really coming into a place of previous price action.

The highlighted area shows another way a moving average may appear to offer support or resistance.

Price has begun to range so the average price that is being calculated, stays virtually the same.  The slowing down of price action allows the moving average to catch up to the current price.

The lesson?

Use the moving average, whatever period, to show you zones of opportunity for trading signals and then look left for the previous price structure.

Learn A Moving Average Crossover Strategy

We have discussed using a single SMA for a trading strategy but did you know you can combine moving averages?

Using a short term moving average along with a long term average, is a strategy that many traders use.

One of the popular crossovers is a golden cross of the 50 and 200 average or the alligator indicator but virtually any periods can be useful.

For this, let’s use a 10 period SMA and the 30 period to give us a larger window to allow price to evolve.  If we use too short of moving average period settings, we will get so many crossovers that they become meaningless.

Our crossover trading strategy will look something like this:

  • The short term SMA crossing the long term SMA to the upside is a bullish sign
  • When the short term crosses over to the downside, we are bearish and only looking for a sell signal
  • We want pullbacks to at least have a close into the space between the two moving averages to give us potential buy and sell signals
  • You can use an average true range to place your stops
  • Consider profit targets or trailing your stop loss to lock in profits

This is the daily chart of Euro Futures and the vertical lines highlight trend changes.

To get into trades, we will use trend line breaks and if price does not allow the drawing of one, we will go to horizontal support/resistance levels.

Simple Moving Average Crossover Trading - EURO FUTURES
Simple Moving Average Crossover Trading – EURO FUTURES

We want to allow the trend direction to confirm so wait for the moving average crossover to occur and we will look for our pullbacks

  1. Price action was sloppy but when the small candlestick closed over the trend line, we could enter long at market or set a buy stop order over highs
  2. The trend has changed bearish and our conditions for a pullback are met.  We can short at the low of the red candlestick that closed below the trend line
  3. Pullback criteria met, we can short
  4. We can see strength in the correction but our trend is intact and our entry trigger, the trend line break, is still in play
  5. Trend change and this pullback fails into a trading range.  We can play a failure test of the lows and go long

You can also set your entry order to the low or high, depending on trend condition, of the candlestick that closed according to our trading plan.

Crossover Summary:

  • Trade in the direction of the trend is determined by the SMA crossover.  If the short term average is on top of the long term average, we are bullish.  Opposite is for bearish
  • We need a candlestick close to be between the two moving averages for trade consideration.  This is our buy or sell signal
  • Our entry trigger is a break of a trend line or the break of the low or high of the candlestick that gave us our trading signal
  • Stop-loss can use the average true range or around the swing low or swing high with a buffer zone
  • Profits can be taken via moving average cross to the opposite direction, profit targets at 2-3X your risk, or use trailing stops

Ensure you have written out your trading plan and covered all the bases including risk management.

How Should You Trade The Simple Moving Average?

There a many moving average strategies you can use but please keep in mind some important things that we’ve talked about here.

Remember I said that the moving average is just a calculation of the past X number of periods.  That is not a trading edge that you should risk money on.

We added in price action using quantifiable market mechanics:  pullbacks (mean reversion) and momentum (via breakouts of ranges into trends).  Now it starts to make a little more sense as we are using something concrete.

You will trade in the path of least resistance which is the trend – until it ends.  This way, unless you are entering when the trend is rolling over, should allow you to manage your trade to lessen risk when price moves in your direction.

As indicated by the charts I have shown, using a moving average as a suggestion of where you should look for trading setups/signals, is a great start.  You then look left to see where the price is pulling back into.

Having price pullback into the space between the 2 lines of the crossover strategy, ensures you are seeing an actual pullback occur.

Advanced traders will read the strength of the corrective move as pullbacks that have momentum, are a warning sign of potential failure.  This will add another level to your trade outcomes as you will learn what pullbacks have a higher probability of advancing in your direction.

In the end, focus on what price is doing and where it is in relation to past price and the simple moving average you choose.

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