Trading with Moving Averages are Simple Strategies that Make Money!

When you start trading with moving averages, you need to decide whether you want to use simple moving averages or exponential moving averages. Neither one is better than the other but you need to know the difference before you start trading with moving averages. Using moving averages is one of the simplest yet effective strategies to trade. If you tend to gravitate toward trend following this strategy may fit you real well. It does not take any exotic programming or fancy computers to run this type of trading strategy.

Here is an explanation of each of the different types of moving averages. You can visit Trading Indicators to view other types of indicators that can be used for trading.

Simple Moving Averages (SMA)

The Simple Moving Average (SMA) helps smooth the price action of a stock to help define the trend and is a lagging indicator built on past data. The Simple Moving Average (SMA) helps filter out noise of the daily volatility of the price action. This is one of the best qualities of moving averages. The name simple moving average defines this trading indicator. It is simply the average of the closing price over the past defined period. Based on the period the SMA will drop off the old data and add the new day. This is why they call it a “moving average”.

The calculation for Simple Moving Averages for a 5 day period is:

Daily Closing Price = $34.45, $34.67, $33.89, $33.54, $33.23

So the SMA of this data is ($34.45 + $34.67 + $33.89 + $33.54 + $33.23) / 5 = $33.96

As a new day is added an old day is dropped and you keep doing this to get your 5 day SMA.

When trading with moving averages you will need to find a charting service that works for you. Most charting services allow you to customize your settings for moving averages. You will have the ability to change the time period and the type of moving average SMA or EMA.

Exponential Moving Averages (EMA)

The Exponential Moving Average also smoothes the price to help define the trend of the stock, but it reduces the lag by applying more weight to the recent prices. This is the main difference between the two different moving averages.

The calculation for the Exponential Moving Averages for a 5 day period is:

SMA: 5 period sum / 5

Multiplier: (2 / Time periods + 1) = (2 / (5+1)) = 0.3333 (33.33%)

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

Using the SMA from the above calculation, here is how it would work.

Day 1 = $34.45 (using EMA you can take the starting closing price as your beginning EMA)

Day 2 ($34.67 – $34.45)*0.3333 + $34.45 = $34.52

Day 3 ($33.89 – $34.52)*0.3333 + $34.52 = $34.31

Day 4 ($33.54 – $34.31)*0.3333 + $34.31 = $34.05

Day 5 ($33.23 – $34.05)*0.3333 + $34.05 = $33.78

Notice the difference between the most recent prices of the SMA $33.96 versus the most recent point of the EMA $33.78. Not a huge difference but over time this can change where you set your support or resistance.

Now that you have a better understanding of the two different types of moving averages, let’s work through some different types of strategies that would work when trading with moving averages.

Two Moving Average Crossovers

There are several ways to make money trading with moving averages; one of the ways is to use a 20 day and 40 day moving average crossover. You can use Exponential Moving Average (EMA), Simple Moving Average (SMA) or a combination of these moving averages. The point of this system is to have a longer slower average combined with a shorter faster average. For this system you are basically looking for the 20 day moving average to cross the 40 day moving average. This is a short term trading strategy that will tend to keep you in the trade somewhere between 1 week and 3 months. It is a very easy strategy to follow and you do not have to second guess the signals. The biggest concern when trading with moving averages is the problem of getting whipsawed.

The only additional step I would take when using this strategy would be to add an additional exit point by either using an ATR or set percentage stop. This will help you with your position sizing model as well as give you a set exit point. The periods described are used to give you an example of what a system would look like when trading with moving averages. Experiment with different time periods based on your trading psychology and temperament.

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Two Moving Average Crossovers

Three Moving Average Crossovers

This works basically the same way the two moving average crossover works with one wrinkle. The third moving average will be your guide. So using the example above 20 day and 40 day crossover add another moving average such as the 50 day, which will be your guide for whether or not to take a crossover trade. For example, if both the 20 day and 40 day are above the 50 day then you would take a trade when the 20 day crosses above the 40 day. If the 20 day or 40 day moving averages are below the 50 day moving average then DO NOT take this trade even if you get a crossover. Again when trading with moving averages, add an additional exit to figure my position sizing and give you a set exit point.

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Three Moving Average Crossovers

EMA & SMA Crossover

This is a very interesting strategy that uses the strengths and weaknesses of each of the different types of moving averages. Remember the EMA weights the most recent price heavier than the rest of the prices, so it tends to not lag as much as the SMA. So with that in mind, you can pair these two different types of moving averages with the EMA being your crossover line and the SMA being your signal line.

This strategy uses the 20 day exponential moving average (EMA) as the fast line and the 40 day simple moving average as the slow line. This is not a big change but it does make a difference in your execution prices based on the chart below. Notice the difference it makes just by changing the 20 day signal line from SMA to EMA. Strategies based on trading with moving averages give you a lot of different options. For this strategy you could even change the period of each moving average to see what was optimal.

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EMA & SMA Crossover

It is very important that you understand, trading with moving averages is a trend following strategy. These type of strategies will not work in sideway and choppy markets. In order for this type of strategy to work, you would need to catch a trend. This should be a no-brainer since it is called a trend trading strategy.

As you are working through trading with moving averages, you need to decide on the time frame that you want to trade. The longer the period the bigger the trend you would be looking to catch. It also would not trade you as much therefore you would have less chance of getting whipsawed. Whipsawed is when your signals continually get you in and out of a position over a short time frame without making money. Trend strategies can have problems in this area and you have to be mentally prepared to handle this type of risk. It is very important to understand this when you are trading. You can find out more about your trading temperament by clicking Trading Psychology.

Not all traders will find that trading with moving averages will work for them. If this is not for you then visit Trading Indicators to learn more about different types of indicators that you can use when trading.

The ultimate goal for every trader is to make money. It takes time and discipline to do this. I hope this information helps you on your journey to become a better trader and make more money!!!

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