Simple moving averages (also known as SMA or MVA) consist of some of the most versatile and widely used indicators in the market. Moving averages can be used for filtering the trend, finding support and resistance levels, and assistance with implementation of strategy. In this article, we’ll examine the most basic of moving averages, the simple moving average, and how it can be used as a trend filter, which can then be used to provide directional biases to strategy.
Moving Averages and Reaction to Price Action
Moving averages are simple technical tools that are designed to measure the average price presented on a chart for a designated number of periods. For example the 200 period moving average is shown below. This means that the closing price has been taken for the last 200 periods, added together and then that sum is divided by the input of ‘200’ to find an average price. Once this number has been established, the average is printed on the graph as a frame of reference, and as each new bar or candle comes in with new information, that will similarly be reflected in the average as the new higher or lower price is registered in the data.
Below we can see a USDCAD daily chart with prices trending downward. You should notice as price trends downward, the moving average will begin moving lower as well. With price moving down faster than the 200 period MVA, this is an indication that prices declining and the prevailing trend is ‘bearish’.Likewise as price moves upward, as it did on the left side of the chart, the average will slowly move towards higher levels, as well. Knowing this, we can now implement the moving average into our analysis.
Image prepared by James Stanley
Trading with a MVA Filter
You may notice from the above chart some incredible lag as it took the moving average quite a while to begin reflecting the down-trend in USD/CAD. This is partially by design, and is a direct function of the inputs being used in the indicator. Because this was a 200 period simple moving average, and because this reversal appears to have been particularly sharp, it took the moving average some considerable time before it too began to head-lower.
But – you may also notice that when prices fell below the moving average, at least for the second time, prices continued to run-lower for an extended period of time. This highlights the potential usage of a moving average as a ‘trend filter.’ So if prices are above the 200 period moving average, traders are looking at bullish strategies while prices below the 200 period moving average highlight the potential for bearish trends and short-side strategies.
After a trader has graded the trend, they then have a directional bias that can be used in a variety of ways. As we discuss in the article looking at popular strategies, trend filters can be used as a type of first step in a strategy, so that traders can then approach the market with a trend-side bias.
Or, even in its most simple of forms, traders can use a moving average filter to gain a potential bias with another indicator that can be used for entries and exits, such as MACD or RSI.
Such a strategy was laid out in the article, MACD Trading Strategy: 3 Steps to Find a Trend. The first step in that strategy is to grade the trend, after which the MACD indicator can be utilized with a trend-side bias.
In the following pages of this section on moving averages, we’ll get into considerably more depth behind this simple yet versatile indicator that can serve traders in a variety of ways.