Friday, March 24, 2006

Thoughts on Moving Averages

Each and every Moving Average will work from time to time. Moving Averages show an Average. Quite obvious, but when you think a bit more about this statement you might get a better understanding of where moving averages can help you in your trading.
For myself I found that it's not one moving average which provides the Holy Grail, be it a 20_ma, a 34_ma or a 50_ma, but a combination of multiple MA's. I see MA's as tools to define an underlying trend and as providing support or resistance.

The Underlying trend is seen in the angle of a longer term MA. Does it point up on the chart we have an uptrend, is it basically flat, we are consolidating in a range and does it point down we have a downtrend. Simple and obvious, but a lot of traders seem to have a problem with that.

Support and resistance, here I use a combination of MA's and I don't try to pinpoint a specific price, that would be Top or Bottom picking. Instead in an uptrend I expect price to bounce somewhere between my short and longerterm MA. For my trading I use a 20 and a 55ema and I have colored a zone between these 2 MA's, so I don't try to pinpoint the entry. Somewhere between these 2 ema's I expect a bounce if the Downtrend as seen on the Euro chart below is about to continue (The black line is a Line on Close chart btw)
Why a zone? Because MA's are a kind of self-fullfilling prophecy, they work because of human behaviour as a group. We all use different MA's but it doesn't matter what MA we use, if price congests, MA's of different length congest as well, so regardless what MA we use, we all see the same picture. Price is nearing my MA from below and bouncing off = Go Short
It doesn't matter what MA you use, you will see the same picture as seen on my chart. To be reminded of that fact, I color a MA zone and I do the same with the Bollinger Bands btw, as I have seen, that they show a similiar behaviour. It's like price pushing into something soft, but not really giving way and you can expect a reversal. But you won't get it from the standard BB 2,20 bands or the BB 2,34 bands or whatever you use, you will get it somewhere and I just define BB ranges I consider important. A congestion of the bands tell me a lot of people will expect a bounce and if that BB congestion is broken we will see a major move ( As seen on the chart, The BB's were white at 1.2100 and it was a small band, which tells me there is a lot of support and it also tells me shorter BB's are above longer BB's, meaning we have real support now, but the Support broke and all traders who went long on that support covered and added to the downtrend.