Trading with Moving Averages Explained

Understanding Moving Averages plus Trading with Moving Averages 

Moving averages, also called MAs in short, are the most widely used and oldest technical indicator used by traders because of its simplicity in both construction and uses. It is among the “Lagging indicators” as it provides signals or direction of price after a significant change in that direction.

Moving averages are very effective in case of trend analysis as this indicator dampen short term fluctuations and smoothen out the price so that a trader or analyst can focus on major or long term price movement, due to this laggard. It is also a very popular indicator as its signals are simple, clear and easy to understand.

Moving averages calculated by taking the close price of the currency pair, or you can choose open, high or low price instead of close price. Moving averages are simply average price of the currency pair for last ‘X’ number of periods. It includes the new price data as it develops hence called moving averages.

Types of Moving Average

There are different types of moving averages, among them 2 types of moving averages are highly popular and widely use. They are,

1. Simple Moving Averages (SMA)
2. Exponential Moving Averages (EMA)

Simple Moving Averages (SMA) :

This is the based on the basic calculation of the moving average as mentioned above; by dividing the sum of the values of ‘X’ number of periods by the number of periods ‘X’. Because of its calculation method it is simple and smoother than other type of moving averages. You can choose any number as periods of any moving average, such as 10, 13, 15, 20, 25, 28, 30 etc. There are some numbers recommended in case of moving averages. Such as 10, 25, 30, 50, 100, 150 and 200; most of the traders use these periods of moving averages.

Calculation of SMA:

SMA of n periods = n period sum/n

n = the period or number of day’s you choose to plot moving averages. Such as 10,20 or 30.

There is an example of simple moving average given in the chart above. We can see SMA25 or 25 day’s simple moving average (blue colored line) in the daily chart of EUR/USD.

Exponential Moving Averages (EMA):

Exponential Moving Averages also known as EMAs. This type of moving averages designed and developed to reduce the lag or delaying nature of SMA by applying more weight on most recent price or data.

Calculation of EMA:

You have to go three steps to calculate exponential moving average. First, you have to calculate simple moving average of your chosen period. Then you have to calculate the weighting multiplier to put more weight in recent price data. Then you can calculate exponential moving average using simple moving average and weighting multiplier which you have calculated before. All three steps of calculation would be like this,

SMA = n period sum/n where, n = number of periods chosen to calculate EMA

Multiplier = (2/ (n+1))

EMA = {Close – EMA (previous day)} x multiplier + EMA (previous day)

Here is an example of EMA in the chart given below,

In the chart above, blue colored line is 30 day’s exponential moving average (EMA30) in the daily chart of EUR/USD.

Simple Moving Averages (SMA) Vs Exponential Moving Averages (EMA) :

Calculation of SMA and EMA is different. Thus, there are some differences in their characteristics. The key difference is the lag factor. If same periods of moving average plotted, then we will be able to see the significant difference. Let’s check out the significant difference between SMA and EMA.

In the daily chart of EUR/USD, we have plotted SMA30 and EMA30. Red colored line is SMA30, and blue colored line is EMA30. These two moving averages have a difference in appearance though they are of same periods. If you look at the chart carefully you will find that, EMA reacts faster with the price than SMA reacts with the price. This means, EMA is faster and choppier than SMA. Thus, SMA is lazier but smoother than EMA. Both SMA and EMA are an effective tool. It depends on trader who has to choose the type and period of moving average he/she will use depending on his/her trading style.

Trading with Moving Averages :

Moving averages can be used for various reasons. Such as,

1. Trend Identification
2. Trend Reversals
3. Dynamic Support and Resistance

Trend Identification :

Moving averages are very useful to identify trend and the direction of the trend. The trend is in an uptrend as price or candle is above the moving average. Inversely, if price/candle is below the moving average and the moving average is heading downward then the trend is downtrend. There is no valid trend (flat trend) if price or candle is in a range with moving average, and the moving average is flat. All these situations have shown in the chart of daily EUR/USD given below.

Trend Reversal:

Trend reversals identified by the crossover between two or more moving averages of different periods. Let’s take two moving averages in consideration, SMA10 and SMA30. SMA10 is faster than SMA30 as its period is smaller than SMA30. When SMA10 crosses above SMA30 then it is a sign that trend has reversed to uptrend from downtrend. We should keep in mind that if short term moving average is below the long term moving average then the trend is down. And if short term moving average is above the long term moving average then the trend is uptrend and if both moving averages stay in the same point then there is no or flat trend. Now, when SMA10 crosses SMA30 from above then it is a confirmation that the trend has reversed to downtrend from uptrend. Both uptrend and downtrend reversals have shown in the example in the daily chart of EUR/USD given below.

Dynamic Support and Resistance:

In an uptrend price tends to get support whenever its price or candle comes near moving average. Thus, most of the times price bounces back to its previous trend from the moving average. This scenario is bullish pullback. Inversely, when a currency pair is in downtrend then it tends to get resistance when price or candle comes near moving average. Thus, price tends to bounce back to downward from this moving average. This is a bearish pullback. Both bullish and bearish pullback has shown in the example chart of daily EUR/USD given below.

In this way, moving averages can be used as dynamic support and resistances.

Conclusion:

All the methods of using moving average are very useful for trend identification. Moving average crossover signals should be used only for trend identification. Trading crossover signals might make you depressed as these are late signals and can provide many whipsaws. Trading the pullbacks near the moving averages is a very effective strategy. However, other momentum indicators or oscillators should be use with moving averages to make a better combination to provide entry signals.

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More About Volatility Indicators – Bollinger Bands Explained

Volatility Indicators – Bollinger Bands Explained

Introduction:

Bollinger band is a volatility indicator developed by John Bollinger. This indicator measures volatility based on standard deviation. Bollinger band is most used volatility indicator and one of the widely used indicators in technical analysis.

Calculation:

Calculation of Bollinger band is based on a simple moving average. The default period of Bollinger band and moving average is 20. However, many traders use Bollinger bands of 15 or 25 periods. The calculation of Bollinger band is as follows,

Middle Band = 20 day SMA or Simple Moving Average

Upper Band = 20 day SMA + (20 day Standard Deviation)

Lower Band = 20 day SMA – (20 day Standard Deviation)

Bollinger band appears as a band consists of 3 moving averages like lines. Here is an example chart containing Bollinger bands.

Interpretation:

Bollinger band can be used in many ways. Different traders use this indicator in different ways. Such as,

1. Bollinger Band Bounce
2. Bollinger Band Squeeze
3. Bollinger Band Breakout

Bollinger Band Bounce:

This is very simple and effective trading method for short term trading. Traders usually use this for short term trading or scalping in forex market. This strategy involves buying when candlestick hit the lower Bollinger band and selling when candlestick hit upper Bollinger band. It is better if you follow the trend while trading Bollinger band bounces.

4 hour chart of USD/CAD is showing several entry signals for both long and short positions.

Bollinger Band Squeeze:

When a currency pair becomes less volatile, Bollinger band becomes squeezed. In squeezed condition, distance between upper, lower and middle bands becomes narrow. This scenario occurs when the price of the pair is ranging in a narrow range. This indicates low volatility and a sign of a breakout or breakdown. Squeezed Bollinger band after a prolonged downtrend indicates accumulation period. Inversely squeezed Bollinger band after a prolonged uptrend indicates distribution period. But it is extremely difficult to identify accumulation and distribution phase properly. This is why traders usually add other indicators to understand the possible price direction after the squeezed state.

On the 4 hour chart of AUD/USD, we can see entry signals for long positions as Bollinger band was squeezed and MACD moved above the zero line.

4 hour chart of AUD/USD (given above) is showing sell signal or entry signal for long position when the Bollinger band was squeezed and MACD crosses below the zero line/centerline.

Bollinger Band Breakout:

A breakout occurs when candlesticks hit upper or lower Bollinger band. Breakouts and breakdowns mostly occur after a squeezed state of the Bollinger band. A squeezed condition of Bollinger band indicates the possibility of a breakout or breakdown. Thus, traders generally trade breakouts or breakdowns after Bollinger band squeeze.

 4 hour chart of USD/CAD is showing breakout and breakdown after a squeezed state of the Bollinger band.

Summary:

Volatility plays a vital role in Bollinger band trading strategies. Such as, Bollinger band bounce strategy works well when there is a confirmed trend and volatility is high. Breakouts and breakdowns carry more success if found after a prolonged squeeze state of the Bollinger band. Traders should consider these factors while trading with Bollinger bands.

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More About Trendline from a different Look -

More About Trend-line from a different Look -

What is A Trend-line ?

Trendlines are drawn with a diagonal line between two or more price pivot points. Look at the Daily chart below of the EUR/USD currency pair.

The pair made a significant swing high on February 1^st of this year, followed by another significant swing high on the 13^th of February. We can now draw a trendline by connecting the highs of these 2 price pivot points. You need a minimum of two price points to draw a trendline, although more is better of course.

How do you trade trend line?

There are two ways to profit from trendlines.
Method number 1 – Look for a continuation of the trend
The first and most obvious one is to look for price to turn once it hits the trendline. The chart below shows areas where price hit the trendline only to turn back down.

Where do you enter and place your stops?
The Entry is when price hits the trendline. These areas are marked with arrows on the chart below. The initial stop loss is placed above the trendline giving us a low risk entry. A trailing stop is also usually employed when trading trendlines. As the trendline moves lower you move the stop loss just above the line, thus lowering your risk further.
Trendlines are dynamic support and resistance levels
Trendlines are support and resistance levels but unlike horizontal lines which are static in nature, trendlines are dynamic. Notice how on the charts above we only connected the first 2 swing points. If we extend the trendline further down we get the chart below.

As price moves lower your trendlines may need to be adjusted somewhat to reflect the new price action. Don’t be afraid to make these changes as adjusting the line can lead to more accurate entries.
Method Number 2 – Look for the trend to reverse
The second way to trade trendlines is to look for areas of possible trend reversal. This happens when the trendline no longer can contain the price. The price makes a brakeout and reverses the previous trend. We have identified one such instance on the chart below.

The big 2 month downtrend in the EUR/USD during February and March is drawing to a close as the single currency starts to turn back up. The trendline is broken and soon after we get the first significant price close above the line. The stop loss is placed just below the price swing low.
An Example from the Long Side
Below is an example on the EUR/JPY 1 Hour chart. It shows the same concepts we talked about before just from the long side. The pair made a significant swing low on April 4^th, followed by another significant swing low the next day. We draw a trendline by connecting the lows of these 2 price pivot points.

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Money Management

 

Protecting your capital (or money management)

The biggest risk that any trader faces is that they will lose their capital. Often new traders will start out with a string of successful trades and their confidence grows: they never learn to apply sound money management and limit their downside risk. Sooner or later they encounter a string of losing trades that either wipes them out or wipes out a big enough portion of their capital that they quit trading.

Uncertainty

No trading system can deliver 100% accuracy. Prices can go up or down at any time: it is only the probability that varies. The best we can hope for is a probability of about 80% (that price will move in a specified direction). That means that at least one in five times you will be wrong and price will move against you. There is no such animal as a "sure thing". In fact, whenever you hear or use those words, you are at more risk of losing your capital than at any other time.

If you can't be 100% accurate, how can you make money?

In the same way that a casino makes money. If the odds are stacked in your favor (compare 80% to the house advantage of less than 55% on a roulette wheel) you will be able to gain more than you lose -- provided that you do not risk all your capital on a single trade.

The market is a dynamic system. I often compare trading to a military operation, not because of its' oppositional nature, but because of the complexity, the continual uncertainty created by conflicting intelligence reports and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected. The formula is simple: trade when probabilities are in your favor; apply proper risk (money) management; and you will succeed.

Money Management: The 2 Percent Rule

The 2 percent rule is a basic tenet of risk management (I prefer the terms "risk management" or "capital preservation" as they are more descriptive than "money management"). Even if the odds are stacked in your favor, it is inadvisable to risk a large portion of your capital on a single trade.

Larry Hite, in Jack Schwager's Market Wizards (1989), mentions two lessons learned from a friend:

1. Never bet your lifestyle -- never risk a large chunk of your capital on a single trade; and
2. Always know what the worst possible outcome is.

Hite goes on describe his 1 percent rule which he applies to a wide range of markets. This has since been adapted by short-term equity traders as the 2 percent rule:

The 2 Percent Rule: Never risk more than 2 percent of your capital on any one stock.

This means that a run of 10 consecutive losses would only consume 20% of your capital. It does not mean that you need to trade 50 different stocks -- your capital at risk is normally far less than the purchase price of the stock.

Applying the 2 Percent Rule

1. Calculate 2 percent of your trading capital: your Capital at Risk
2. Deduct brokerage on the buy and sell to arrive at your Maximum Permissible Risk
3. Calculate your Risk per Share:Deduct your stop-loss from the buy price and add a provision for slippage (not all stops are executed at the actual limit). For a short trade, the procedure is reversed: deduct the buy price from the stop-loss before adding slippage.
4. The Maximum Number of Shares is then calculated by dividing your Maximum Permissible Risk by the Risk per Share.

Example

Imagine that your total share trading capital is $20,000 and your brokerage costs are fixed at $50 per trade.

1. Your Capital at Risk is: $20,000 * 2 percent = $400 per trade.
2. Deduct brokerage, on the buy and sell, and your Maximum Permissible Risk is: $400 - (2 * $50) = $300.
3. Calculate your Risk per Share:
   If a stock is priced at $10.00 and you want to place a stop-loss at $9.50, then your risk is 50 cents per share.
   Add slippage of say 25 cents and your Risk per Share increases to 75 cents per share.
4. The Maximum Number of Shares that you can buy is therefore:

$300 / $0.75 = 400 shares (at a cost of $4000)

Quick Test

Your capital is $20,000 and brokerage is reduced to $20 per trade. How many shares of $10.00 can you buy if you place your stop loss at $9.25? Apply the 2 percent rule.

Hint: Remember to allow for brokerage, on the buy and sell, and slippage (of say 25 cents/share).

Answer is--

---

Answer: 360 shares (at a cost of $3600).
Capital at Risk: $20,000 * 2 percent = $400
Deduct brokerage: $400 - (2 * $20) = $360
Risk per Share = $10.00 - $9.25 + $0.25 slippage = $1.00 per share
Maximum Number of Shares = $360 / $1 = 360 shares

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Is 2 Percent Suitable For All Equity Traders?

Not all traders face the same success rate (or reliability as Van Tharp calls it in Trade Your Way to Financial Freedom). Short-term traders normally achieve higher success rates, while long-term traders generally achieve greater risk-reward ratios.

Success Rate (Reliability)

Your success rate is the number of winning trades expressed as a percentage of your total number of trades:

Success rate = winning trades / (winning trades + losing trades) * 100%

Risk-Reward Ratios

Your risk-reward ratio is your expected gain compared to your capital at risk (it should really be called the reward/risk ratio because that is the way it is normally expressed). If your average gain (after deducting brokerage) on winning trades is $1000 and you have consistently risked $400 per trade (as in the earlier 2 percent rule example), then your risk-reward ratio would be 2.5 to 1 (i.e. $1000 / $400).

Risk-Reward ratio = average gain on winning trades / average capital at risk

Confidence Levels

If we have three traders:

Trader:	A	B	C
Time frame:	Short-term	Medium	Long-term
Success Rate:	75%	50%	25%
Risk-Reward Ratio:	1.0	3.0	10.0

Trader A

Trades short-term and averages 125% profit over all his trades.

Winning trades:	75% * 1	0.75
Less: Losing Trades	25% * 1	-0.25
Average Profit		.50
As a percentage of capital at risk		50%

Trader B

Trades medium-term and averages 200% profit over all his trades.

Winning trades:	50% * 3	1.50
Less: Losing Trades	50% * 1	-0.50
Average Profit		1.00
As a percentage of capital at risk		100%

Trader C

Trades long-term and averages 325% profit over all her trades.

Winning trades:	25% * 10	2.50
Less: Losing Trades	75% * 1	-0.75
Average Profit		1.75
As a percentage of capital at risk		175%

This does not necessarily mean that Trader C is more profitable than A. Trader A (short-term) is likely to make many more trades than Trader C. You could have the following situation:

Trader:	A	B	C
Time frame:	Short-term	Medium	Long-term
Average Profit/Trade	50%	100%	175%
Number of Trades/Year	300	100	40
Times Return on Capital at Risk	150	100	70
Capital at Risk	2%	2%	2%
Annual % Return on Capital	300%	200%	140%

Relative Risk

We now calculate the relative risk that each trader has of a 20% draw-down. Use the binomial probability calculator at  http://faculty.vassar.edu/lowry/ch5apx.html:

Trader	A	B	C
Success Rate	75%	50%	25%
Probability of 10 straight losses	0.0001%	0.1%	5.6%

Obviously, the higher your success rate, the greater the percentage that you can risk on each trade.

Bear in mind that, with a higher risk-reward ratio, Trader C only needs one win in 10 trades to break even; while Trader A would need five wins. However, if we compare breakeven points, it is still clear that lower success rates are more likely to suffer from draw-downs.

Trader	A	B	C
Number of wins (out of 10 trades) required to break even	5	2.5	1
Normal Success Rate	75%	50%	25%
Probability of making a net loss in 10 trades	2.0%	5.5%	5.6%

Low Success Rates

Although your trading system may be profitable, if it is susceptible to large draw-downs, consider using a lower percentage of capital at risk (e.g. 1 percent).

Back to the Real World

In real life trading we are not faced with a perfect binomial distribution as in the above example:

• gains are not all equal;
• some losses are bigger than others -- stop losses occasionally fail when prices gap up/down;
• probabilities vary; and
• outcomes influence each other -- when stocks fall, they tend to fall together.

Covariance

The biggest flaw in most risk management systems is that stock movements influence each other. Individual trades are not independent. Markets march in unison and individual stocks follow. Of course there are mavericks: stars that rise in a bear market or collapse in the middle of a bull market, but these are the exception. The majority follow like a flock of sheep.

Thomas Dorsey in Point & Figure Charting gives an example of the risks affecting a typical stock:

Market risk Sector risk Stock risk

66% 24% 10%

The risk of the market moving against you is clearly the biggest single risk factor. How do we protect against this?

Protecting your Capital from a String of Losses

The 2 percent rule alone will not protect you if you are holding a large number of banking stocks during an asset bubble; insurance stocks during a natural disaster; or technology stocks during the Dotcom boom. We need a quick rule of thumb to measure our exposure to a particular industry or market.

Independent Sectors

Limit your exposure to specific industry sectors. Not all sectors are created equal, however. Industry groups in the (ICB or GICS) Raw Materials sector have fairly low correlation, and can be treated as separate sectors, while industry groups in most other sectors should be treated as a single unit.

We can see from the above chart that Chemicals and Containers & Packaging tend to move in unison and should possibly be treated as one industry sector, but other indexes shown are sufficiently independent to be treated separately.

Sector Risk

As a rule of thumb, limit your Total Capital at Risk in any one industry sector to 3 times your (maximum) Capital at Risk per stock (e.g. 6% of your capital if you are using the 2 percent rule).

This does not mean that you are limited to holding 3 stocks in any one sector. You may buy a fourth stock when one of your initial 3 trades is no longer at risk (when you have moved the stop up above your breakeven point on the trade); and a fifth when you have covered your risk on another trade; and so on.

Just be careful not to move your stops up too quickly. In your haste you may be stopped out too early -- before the trend gets under way.

I also suggest that you tighten your stops across all positions in a sector if protective stops are triggered on 3 straight trades in that sector (within a reasonable time period). By protective stops I mean a trailing stop designed to exit your position if the trend changes (e.g. a close below a long-term MA). A reasonable time period may vary from a few days for short-term trades to several weeks for long-term trades.

Market Risk

You can limit our market risk in a similar fashion.

Limit your Total Capital at Risk in the market to between 5 and 10 times your (maximum) Capital at Risk per stock (e.g. 10% to 20% of your capital if you are using the 2 percent rule). Adjust this percentage to suit your own risk profile. Also, the shorter your time frame and the higher your Success Rate, the greater the percentage that you can comfortably risk.

It is also advisable to tighten your stops across all positions if protective stops are triggered on 5 straight trades within a reasonable time period. Protective stops do not have to be the original stops set on a trade. You may make an overall profit on the trade, but the stop must indicate a trend change.

Money Management Summary

A general rule for equity markets is to never risk more than 2 percent of your capital on any one stock. This rule may not be suitable for long-term traders who enjoy higher risk-reward ratios but lower success rates. The rule should also not be applied in isolation: your biggest risk is market risk where most stocks move in unison. To protect against this we should limit our capital at risk in any one sector and also our capital at risk in the entire market at any one time.

 

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