Moving averages can be used for lots of things in trading, lets look at them now.
Trend confirmation
The primary use for moving averages is trend confirmation. The way to resolve the lag factor issue in your analysis is to use three moving averages, each with a different time period.
20 period SMA 50 period SMA 200 period SMA
Assessing the trend
To assess the direction and quality of the trend, for a long term upward trend the following needs to be checked:
| Price vs. SMA | Slope | Both correct? | |
| 200 Period SMA | Above | Up | Yes |
| 50 Period SMA | Above | Up | Yes |
| 20 Period SMA | Above | Up | Yes |
The opposite is true for a long term downtrend.
If any of the checks fail then it means our confidence in the trend is reduced.
As a trade signal
Some trend following traders use moving average crossovers to trade trends. They place two moving averages on a chart, say 20 and 50-period SMAs. When the shorter-term MA crosses up over the longer-term MA that is a trigger to buy. When it crosses back down over it that is a signal to exit the long trade and short the market.
This trade strategy is fantastic when markets trend for long periods, the issue is when they don’t – it creates lots of false signals and ends up costing the trader money.
As a risk management tool
Because it lags, moving averages are an excellent tool for traders to set and refine stop losses. Tracking a stop loss to a moving average locks in profits as a trade matures.
To find support and resistance
Lots of traders are looking at moving averages, and in some cases using them to enter or exit trades. This means it can be used as a tool to identify potential support and resistance levels in the market.
- Traders use moving averages to confirm the direction of the trend.
- Use three MAs and check whether the price is above or below each, and the direction of the MAs slope to establish your confidence in the trend.
- Some traders use moving average crossovers as a trade signal. This method captures the big trends, but if the market is non-trending the trader will be stopped out a lot.
- MAs are a good, simple way of setting and refining stop losses.
- Because it is a popular indicator it acts as dynamic support and resistance areas.
