Just about any simple moving average trading strategy needs a good trending market to be an effective trading strategy.
Once a trading chart starts showing consolidating price action, the moving averages become virtually useless although moving averages converging can help you objectively identify a market in chop.
There are trading strategies that take advantage of consolidations and those are either trading the range or using a breakout trading strategy. Understanding various methods of technical analysis to identify favorable range trading conditions are something traders should learn so they are not caught up trading consolidations when they think they are trading a trending market.
This moving average trading strategy is going to focus on trading pullbacks in a trending market and we will combine it with measures of:
- The strength of the trend we are trading
- If price is either oversold or overbought
You can use this trading strategy in Forex or other markets and as either a day trading approach, swing trading, and even position trading.
Difference Between Simple Moving Averages And Others
In reality, the differences between various forms of moving averages will not improve a trading strategy to any measurable result. We are using simple moving averages as a matter of course and by using the SMA, we will just be using the last X days average of price.
Exponential moving averages takes into account more data than the period used although the impact of historical price data decays over time.
Let’s keep things simple and stick to the SMA
Time frames – You can use lower time frames such as 5 minute charts higher time frames (4 hours – daily chart) are my favorite time frames for trading Forex
Currency – Any currency pair but stick to the currency pairs that move such as EURJPY, EURUSD, GBPUSD
Indicators – 5 and 10 simple moving averages (SMA), stochastic oscillator 14,3,3, and RSI setting of 9
We are using stochastic at 80/20 for oversold and overbought markets
RSI (relative strength index) – Measure of trend strength
Trend Determination Using Moving Averages
The 5 SMA is a fast moving average and we will combine it with the slightly slower 10 period SMA. When the 5 crosses the 10 to the upside, we will assume we are in an uptrend
When the 5 crosses to the downside over the 10 simple moving average, assume we are in a down trend.
This is a nice objective way to measure the trend although using any technical indicator, you will have a lag between the price action and the indicator showing the trend change.
Trading Strategy Rules
As with any trading strategy, you must follow the rules or you will not find much success. Even better, make sure you put together a trading plan that dictates every move you will make in the markets.
Let’s take a look at how a sell signal will show up on the chart and how you will trade the signal.
- The first thing we look for is a crossing of the 5 period simple moving average over the 10 SMA to the downside
- Look to see that the RSI is either crossing or has crossed the 50 level which indicates the momentum is to the downside
- Has the stochastic left the overbought area or in the process and trending to the downside?
- IF all the above are yes, place a sell stop order below the low of the candlestick that turned the moving averages
That is how you will determine a short trade and before you trade the sell signal, ensure you know where you will get out if wrong. We will cover stop loss positions later. The candlestick shown as the setup candlestick may NOT be the one that actually turned the moving averages.
Remember, moving averages are lagging indicators and it may have been the next one that showed the clear turn.
A buy signal is the opposite of the sell signal.
- Noted the moving averages have crossed over and the 5 period SMA is above the 10 period
- Relative strength index has already crossed over the 50 level indicating an uptrend
- Stochastic has crossed from oversold and is heading upwards
- A buy stop order is placed above the high of the candlestick that turned the moving averages
The only difference between a sell signal and a buy signal is the direction the indicators must show.
Stop Loss For Simple Moving Average Trading Strategy
I am not a believer in a set number of pips for a stop loss. You have various techniques you can use for a protective stop loss:
- Use the high or low of the setup candlestick and place your stop below (above) that candlestick. This is dynamic as every candlestick will have a different range in price.
- Use an average true range to place your stop loss. I’ve covered this and other stop loss placement methods in another blog post.
Whichever method you use, the key is to be consistent with all your trading setups. This is why you need a trading plan to ensure you stay on the right track.
Take Profit Strategies
Like stop loss placement, taking your profits is not one size fits all.
You can read this article, Let Profits Run, to see how to take full advantage of what the market is offering instead of taking only a few pips from the move
Some traders will target various support or resistance levels to exit their trade. Here is a support and resistance indicator for Metatrader you can download.
Fibonacci Price Targets
I must say that one of my favorite ways of finding profit targets for any strategy including a moving average trading strategy is Fibonacci extensions.
As you can see in this chart, price found all 3 targets including finding the top at the 200% level measured from the previous swing.
I may do an article on how to use Fibonacci in terms of taking profits. I find it incredibly useful as the various levels also act as areas to scale out partial profits.
As you can see, this is a simple moving average trading strategy that takes into account trend and momentum for your trading signals.
Ensure you use proper stop losses, risk control, and you find ways to take what the market is offering without knee jerking out of your trades.
If you prefer a trading strategy without moving averages, take a look at this one: Stochastics and Supertrend
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