Here’s a quick post on how I use moving averages. In the past, I’ve referenced this method as ‘tagging the average’.
Up until now though, I haven’t devoted a full post to it.
I like to keep my charting naked. I don’t use price indicators, don’t use support resistance but I do use moving averages.
One of the first ports of call for all newbie traders are moving averages.
They can be very useful for making trading decisions.
They are not generally useful however as primary entry signals.
What do I mean by primary entry signals?
There are two common primary signals for moving averages.
The moving average crossover strategy.
And a new close above (below) the moving average strategy.
The moving average crossover strategy
A crossover signal is, for example when a 10-day moving average crosses a 30-day moving average. As the cross occurs you get the entry signal.
You can read this decent article about crossover systems.
Crossovers work best in strongly trending markets.
The problems occur when markets are not trending. In sideways markets, you can easily be cut up.
The close above (below) the average strategy
When a bar first closes above a moving average it can be used as a signal to buy.
For example, closes above a 50-day or 200-day moving average are considered highly bullish.
And sometimes this type of entry can work great.
If you scan a chart, your eye will automatically be drawn to the periods when price closes above (below) the moving average and doesn’t look back.
What your eye is rarely drawn to, are the many instances where price closes above (below) an average and then proceeds to give back all the profits.
Either the very next day or a few days later, by closing back below the average.
This type of system can lead to heavy whipsaw losses – I know, I spend a good couple of years obsessed over this simple approach.
While this method may even win long-term it has a very low win ratio.
Tagging the average
Moving averages are much better as a secondary tool.
Combined with price patterns, momentum indicators, sentiment surveys or even fundamental analysis robust trading systems can be built using them.
For my own trading, I use what I have like to call, ‘tagging the moving average’. With this approach, you can get some of the the highest quality setups, while ignoring many of what end up as quick reversals, or scratch trades.
Note that tagging is only needed if; on the most recent bar, the close is below the moving average when wanting to go long.
Or, the close is above the moving average if wanting to go short.
Tagging acts as a counter-trend trading filter.
The consensus view is you should never trade counter-trend.
You should only take long trades above the average, or short trades below it.
And yet, look at most price charts and you’ll see, many price moves contradict this view.
Take a look at the chart of Cable below.
You can see the black 10-day simple moving average.
You can also see, circled, the Harami Inside Bar setup.
And there is a red mother bar ‘tagging’ the black line.
This signal fully occurs below the 10-day moving average, but (IMO) is a valid signal because…..the red mother bar tags the moving average.
The tag signifies momentum is changing.
A break of the high of the inside bar, adds even more weight to that thesis.
And as you can see the trade worked out well.
No tagging – ignore the setup
Here is another chart of Cable below.
Again, you can see the 10-day moving average.
And the circled, Harami Inside Bar setup.
But can you notice that neither, the mother bar, nor the inside bar touch the average?
That’s an invalid long signal.
It’s a shame – it would have made money
But, with signals that fail to tag the average, you always need to be wary. Momentum is not on your side.
So, if you want high win ratios, with the best R multiples – it pays to use the tagging filter!
Valid and invalid signals on the dollar
Now here’s something of interest to all you anoraks out there!
First up, a chart of the USD/CHF.
Again the 10-day moving average is tagged by the red mother bar. A valid signal.
The market has a quick sharp rise after the pattern is triggered.
Now take a look at this chart. The same day. Different pair.
Notice how the pattern didn’t tag the moving average?
If you had been looking to go long the dollar, the better pair would have been the USD/CHF.
Sure, in these two examples both made money – but going counter-trend without the tag, can lead to catching falling knives. So beware!
Do I always use a tag as a filter?
If I’m particularly bullish on a market I will not look for a tag at all.
Right now I avoid tagging, on any counter-trend gold longs.
But, if you trade multiple markets (I trade twenty US stock CFDs, major currencies, oil & gold) then employing a filter can stop you from becoming overwhelmed.