Moving averages are one of the most popular trading tools used by technical analysts. However, there are many myths and misconceptions about how to use moving averages effectively. This article will debunk some of the biggest myths about moving average trading.
Moving averages are lagging indicators that smooth out price data by creating a constantly updated average price. The two most common types of moving averages are the simple moving average (SMA) and the exponential moving average (EMA).
Moving averages are popular among traders because they help identify trends, provide dynamic support and resistance levels (HINT: look left for price structure), and generate trading signals when the price crosses the moving average. However, there are many myths about how moving averages work and how to use them properly.
This article will debunk five of the most common moving average trading myths and provide tips for using moving averages effectively as part of a complete trading strategy. Knowing the truth about these myths can help improve results and avoid costly trading mistakes.
Myth 1: Moving Averages Predict Future Price Movements
One of the biggest myths about moving averages is that they can accurately predict where the price is headed. However, this is not true. Moving averages are lagging indicators, meaning they are based on past prices and always lag behind the current market price. On this chart, the moving average is pointing upwards, and just by using the average would you predict the next move down?
Moving averages do not predict, they react. They confirm trends and can identify potential support and resistance levels, but they cannot predict precise turning points or future breakouts. Assumptions should not be made about future price action based solely on moving average signals.
A trader that understands price action would have noticed the momentum on the chart on the left, the distance price is from the moving average, and would have been thinking that mean reversion was about to take place.
Myth 2: You Should Only Use One Moving Average
Many traders believe that only one moving average is needed on a chart. However, using multiple moving averages of different periods provides a more complete picture.
Common moving average pairs include the 50-day and 200-day SMAs or the 20-day and 50-day EMAs. The longer moving average identifies the primary trend, while the shorter moving average identifies the short-term trend. In this chart, we can see the 200 moving average is showing a longer-term downtrend. The 20 period shows pullbacks and ranges in the context of a downtrend.
Using this information, traders would look at breakouts to the downside when seeing a flat moving average. With pullbacks, traders would look for a reversal trigger to the downside.
Using moving averages of different lengths allows traders to identify both long and short-term trend direction. This provides more robust signals and helps avoid whipsaws. Relying on just one moving average period leads to an incomplete analysis.
Myth 3: Moving Average Crossovers Are All You Need
While moving average crossovers can generate trade signals, they should not be the sole basis of a trading strategy. Simply going long on golden crossovers and short on death crossovers often leads to whipsaws and poor trading performance.
To improve the odds, moving average crossovers should be combined with other technical analysis techniques like support/resistance, chart patterns, and perhaps momentum indicators. Acting only on moving average crossovers ignores the larger market context around those crossovers.
For best results, a moving average crossover should occur within the direction of the larger trend, and be confirmed with other signals like higher volume, chart patterns, or a support/resistance break. Moving average crossovers on their own is not enough for trading success.
Myth 4: Always Trade in the Direction of the Moving Average
It is a common myth that you should always trade in the direction of the moving average slope. This is not always the optimal approach.
Sometimes the price will pull back from a moving average, which actually creates a trading opportunity in the opposite direction. For example, in an uptrend the price may retrace to the 50-day SMA, setting up a bounce play. This chart shows momentum in price that is extended away from the average. A trading range breakout fails to produce a second leg and the downside begins with a strong reversal.
Blindly trading toward the moving average can lead to missed profit opportunities when counter-trend setups form. Moving averages should be used in conjunction with other analysis techniques to identify the very best trade entries in any market condition.
Myth 5: Moving Averages Guarantee You Will Make Money
One of the most dangerous myths about moving averages is that they somehow guarantee trading success and big profits. This could not be farther from the truth. No single indicator can assure success on its own.
Moving averages, like all technical indicators, are just tools. They must be used wisely as part of a complete trading plan that also incorporates risk management. Even with the most optimal moving average strategy, losing trades will happen. No trading approach wins 100% of the time.
Assuming moving averages are a guarantee to easy profits is a recipe for failure. Respect their limitations, use proper risk protocols, and remember that successful trading requires skill, discipline, and planning.
Tips for Successful Moving Average Trading
While moving averages have limitations, they can improve trading performance when used properly. Here are some tips for getting the most out of moving average analysis:
- Use two or more complementary moving averages to define both short and long-term trends
- Combine moving averages with other indicators like volume (chart FX futures), support/resistance, and candlestick patterns for confirmation
- Avoid putting stop-losses right on the moving average line since some whipsaws are expected
- Look for overbought/oversold indicators to identify exhaustion moves at moving averages
- Focus on high-probability moving average crossover signals that occur in the direction of the larger trend
- Always wait for confirmation before acting on any moving average signal
- Define both entry and exit points before entering a trade based on moving averages
- Manage risk properly on every trade, no matter how strong the moving average signal
- Look left of the current price when near a moving average to find a support/resistance structure.
- Adjust your moving average periods and combinations periodically to optimize for current market conditions
Following these tips can help improve results and avoid frustration when including moving averages into an overall trading plan. But remember, no indicator or system works perfectly. Managing risk and controlling emotions is critical for long-term trading success.
Moving averages are extremely useful trading tools, but only when used properly and combined with other analysis techniques. Avoid falling for common moving average myths that can impair trading results. Use moving averages as one component of a larger trading strategy with proper risk management.
Debunking these moving average myths can help traders form realistic expectations and use moving averages more effectively. Keep learning, review your trading statistics, and stick to high-probability setups. Understanding the realities of moving average analysis leads to improved trading decisions.