The moving average is most efficient in trending markets
One of the most popular tools used by technical analysts is the moving average. Its strength lies in the fact that it offers analysts a trend-following tool to catch major moves. The moving average is utilized most efficiently in trending markets. However, as moving averages are lagging indicators, they can capture a trend only after it has turned.
The Exponential Moving Average is preferred over the Simple Moving Average
The longer the moving average, the less impact a single price will have on it. The shorter the term of the moving average, the closer it will embrace prices. On the positive side, it is more sensitive to recent price action. The negative angle is that it has a greater potential for whipsaws.
Longer-term moving averages provide a greater polishing effect but are less responsive to recent prices. Note that most moving average systems use closing prices.
The difference with other moving averages is that the exponential moving average incorporates all prior prices used in the data. The past prices are assigned progressively smaller weights, hence the name exponential moving average.
How to use moving averages in trading systems
Moving averages can provide objective strategies with clearly defined trading rules. Many automated technical trading systems are substantiated by moving averages.
Prevailing uses of the moving average incorporate:
- Comparison of the price versus the moving averages as a trend indicator. For example, a good measure to see if a market is in an intermediate-term uptrend could be that prices have to be above the 65-day moving average. For a longer-term uptrend, prices should be higher than the 40-week moving average.
- Usage of the moving average as support or resistance levels. A close above the specified moving average would be bullish. A close below the moving average would be bearish.
Analyse the market prices by combining moving averages and Japanese candlesticks
The next example illustrates how moving averages can be combined with Japanese candlesticks. Look at the 65-day moving average that offered support to the market in areas 1, 2, and 3. Besides the moving average ascending the market prices at these points, note also the bullish engulfing pattern at area 1, the hammer and harami at area 2, and another hammer line at area 3.
Example of Simple Moving Average with Japanese Candlesticks
Usage of dual moving averages
When comparing the short-term momentum to a longer-term momentum, the short-term moving average is more responsive to recent price activity. If the short-term moving average is relatively far above (or below) the longer-term moving average, this indicates the market is overbought (or oversold).
Another way of using dual moving averages is to monitor crossovers between the short-term and longer-term moving averages. When the shorter term moving average crosses the longer-term moving average, this could be interpreted as an early warning of a trend change.
For example, if a shorter-term moving average crosses above a longer-term moving average, this considered a bullish signal. In Japanese technical analysis, such a moving average crossover is called a golden cross.
A dead cross is the opposite. This bearish signal occurs when the shorter-term moving average crosses under the longer-term moving average.
An overbought market can relieve its condition by selling off or by trading sideways. In overbought markets, it is better not to short. Instead, these conditions should be used by longs to take defensive measures. The reverse applies to oversold markets.
Monitor the difference between the short-term moving average and the long-term moving average
When the difference between the short- and long-term moving averages narrows, the HitBTC market is indicating that the short-term momentum is losing strength, suggesting the price advance to end.
The histogram in the example below shows when the short-term moving average crosses above or below the long-term moving average. When the histogram is below 0, the short-term moving average lies under the long-term average. When it is above 0, the short-term average lies above the long-term moving average. So, an oscillator reading under 0 represents a bearish dead cross; above 0 would describe a bullish golden cross.
Example of Dual Moving Averages with Japanese Candlesticks
This concludes our overview of the combination of Japanese candlesticks and moving averages. In our final post, we will finish this Introductory Training Course by exploring the usage of candlesticks with oscillators.
Source: Japanese Candlestick Charting Techniques (by Steve Nison)