There are several reasons why we simplify the wording and concepts in our weekly “is the trend still your friend?” article for our readership. The main one being that we have to create an article appealing to all abilities with particular attention being focused on new traders. There’s little point in us over complicating the process of indicator based trading methods and losing the attention of a proportion of our growing community. Likewise and despite opinions to the contrary, there are many traders who have used indicators highly effectively over the decades to consistently pull profit out of our markets. In short indicator based trading methods are excellent ways for many traders, in particular those new to our industry, to attempt to unravel the conundrum of trading.
Simple moving averages – SMAs
Simple moving averages are indicators that are often overlooked, misused or maligned in our industry. They’re often overlooked as, once we’re past our brief apprenticeship, we tend to believe that trading must be complicated and that complication has to match the difficulty we experience when trying to take profit out of the market. We observe the simplicity of moving averages and believe that they’re either irrelevant, or for newbie traders as something that is that simple it could not possibly work. However, used correctly, particularly to ensure you’re on the right side of the trade, simple moving averages can ensure traders are tilting the chances of profitable trading in their direction.
Simple moving averages or SMAs are just one of a number of indicators that we can use in order to determine that (as day traders or swing traders) we don’t find ourselves the wrong side of market moves and we’ll discuss several in this article, however, it’s the simplicity of moving averages and how to determine that we are on the right side of the trend that we wish to concentrate on in this article.
How we traditionally use them
Another aspect of SMAs (simple moving averages) that’s often overlooked is the traditional crossovers, and yet this very basic divergence technique can often be found in many other indicators and made useful to determine direction. Indicators such as the MACD, the DMI and Bollinger bands. With the MACD we clearly see three simple moving averages at work which “converge” and “diverge” in order to deliver a reading typically above or below the zero line which can provide a trigger to enter as part of our high probability trading step up. In another trading method, using cross overs such as the 9 day crossing the 21 day on a daily chart, we can clearly see a divergence from the mean; price accelerates away from the mean to potentially provide a market entry point.
Using moving averages to determine trend whilst ensuring we take day trades the right side of the trend
We can use four main simple moving averages to determine trend they are the: 21, 50, 100 and the 200 SMA. In theory we’ll refuse to take a day trade until price is either below or above these averages. If we are looking to short the market in our security then we’ll only take trades if price is below all the moving averages. If we’re looking to go long then we’ll ensure that price is above all the afore-mentioned simple moving averages. However, we could be bolder and more aggressive in relation to our trading and decide that, rather than using the 200 SMA, we’ll defer to using the 100 SMA. If price on given security breaches our 100 SMA displayed on our daily chart to either the upside or the downside then we’ll take the trade accordingly.
Why the larger moving averages appear to work
There are two schools of thought as to why the larger moving averages, such as the 100 and 200 SMAs, actually ‘work’. Firstly they’re self-fulfilling prophecies. As more and more traders recognize their value when making trading decisions the more decisions will be made around these critical lines on our charts.
Secondly institutional level traders rarely use complicated measurements or indicator clusters to make their decisions with regards to buying or selling a particular security. It’s far more likely that they’ll place their buy, sell and take profit limit orders at convenient spots in the market and adjust them on a micro basis as the market ebbs and flows.
For example, they may place their buy orders close to the 200 SMA on the basis that historically price moves through this market level once breached. Alternatively a trader may wish to trade the rejection of this key number and place a sell order for a short term trade at the 200 SMA reading, or we may prefer to close our trade which has meandered through the two critical points of the 100 and the 200 SMA. There are also the Fibonacci retracement areas that traders may consider placing their orders near.