Why You've Been Using Moving Averages Incorrectly
Every technical trader worth his salt has used moving averages (“MAs”) in some way or another. Whether you use simple, exponential or other, you know that these can be powerful tools for your trading toolkit. But, have you been using these averages all wrong?
Traders generally use MAs with a crossover system, where a bullish signal is triggered when prices move above the moving average and a bearish signal is triggered when prices move below the moving average. But this is not really the most-effective way to use MAs, as it can be unreliable in giving you accurate buy and sell signals.
The one technique that most traders never consider is examining the slope of a moving average. Let’s take a look at a chart of Broadcom Corp. (BRCM):
If you had just followed a simple crossover system to identify entry points, you would have entered where marked and would have been in an unprofitable position. This is a common mistake that many inexperienced technicians make.
If the MA is flat (moving sideways), there is no trend in place and the stock will tend to move above and below the MA identifying several false entry points. Also, you should never trade against the direction or slope of the MA. In other words, if the MA is sloping upwards and the price of the stock moves below the MA, that would not be a valid entry for a short sale and vice versa for long trade entries.
Now, let’s see what happens when you consider a chart where the slope of the moving average is in your favor. For example, here on a chart of EQT Midstream Partners (EQM):
You’ll notice that when the MA is sloping significantly upwards and the price action either moves below and then back above the MA or just retraces back to the MA without breaking below it you could have entered a long trade with a high probability of having a profitable trade. The opposite would be true for short trades.
See a full video explanation of our Slope theory here.
MAs are one of the core techniques of technical trading. However, what separates the successful traders from the average ones is the use of these techniques. While traditional methods will serve you well, never discount the use of enhancements and modifications to improve your winning trade percentage. To learn more about using simple indicators to improve your trading performance, join us for a free live webinar.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.