One of the first technical tools that you will come across in the early steps of your trading journey is perhaps that of the Moving Average.
It is a very useful technical tool as it identifies the direction of the market.
Just to remind you that the market may have 3 possible directions:
- Up
- Down and
- Sideways
When prices move above the moving average line, then it is considered an upward move or uptrend in technical analysis lingo.
Conversely when prices move below the moving average then it is considered a downward move or a downtrend.
When there is a strong trend in either direction the Moving Average tools come in very handy.
Although the moving average follows the price action, it doesn’t provide literal predictions and therefore is considered a lagging indicator.
In simple words, it’s an indicator that suffers from a delay in identifying the signals.
One of the moving average parameters is that of the period.
This means how many prices it will consider in each calculation.
For example, if the period is 50 then it will average the last 50 prices.
On the other hand, if the period is 200 then it will average the last 200 prices.
The longer the period of the moving average, the bigger the lagging factor is and the more the delay in the signal.
But once again, in a trending market, the moving average will work pretty well.
Now the question is, what period should I use?
There are different ways to choose the periodicity of the moving average, but for now, let’s use the market conventions.
10, 20, 40, 50 for the foreign exchange market and 100 and 200 for the stock market.
Now the third direction in the markets is that of the sideways, the range or trendless market as it is also known.
During a range, prices will fluctuate up and down the moving average triggering false signals.
Consequently, false signals will have a negative effect on your account.
So, during a range, I try to make sure that I don’t use the moving average.