Moving Averages:
The first tool I want you to begin using is the easiest to use and configure. What makes it great is the fact that it’s the one that we use the most and rely on the most. The key here is in the configuration.
What is a moving average (MA)
A moving average is the average price of a stock or indices etc. over a defined period of time. These times are pre-configured in the setup of the moving average (MA).
It is this important step on setting up the correct use of the moving average that gives us the power in the tools. As we set up three moving averages to give us the Open, Close and Moving Stop Loss position.
What the moving average does for us is it smoothes out the choppy nature of charts to present the data in a smooth flowing line. It is this and the combination of three differing types of MA and a further long term moving average that provide us with a good focus on spotting the trading signals that we look for.
There are two types of moving average that you need to know about as we use both. They are equally important so pay attention.
The Simple Moving Average (SMA):
The simple moving average is the most basic (hence the simple name) of the tools that we use, but with simplicity comes reliability and ease of use, which we get in abundance with the simple moving average.
The simple moving average is calculated on a predefined number of days, to which it calculates the average price over the past-predefined number. This is then presented on the chart as a line that undulates as the price in the chart changes, therefore, showing you a smoothed out line, representing the average of the prices over that set number of days, whether it’s over 999 days or 1 day.
On the next page I shall show you what predefined criteria you need to first set in your charting service or program for the Simple Moving Average. Together with the colour coding to use to make the price movements stand out better.
I will give you the configuration for the simple moving average in a minute, after I have explained the other moving average that we use.
Exponential Moving Average:
The exponential moving average is different to the simple moving average, in that it adds more weight to recent data than it would to old data. Whereas the SMA take all the data over a preconfigured range as the same weight.
Say for instance we wanted a moving average to cover 100 days. The SMA – simple moving average will take all the data, from 100 days ago up to today and treat the data that is 100 days old and give it the same weight (importance) as that of recent data, say that from today.
Whereas the exponential moving average (EMA) will take the same data, but this time add more relevance to recent data, than it would with data charts 100 days old.
Now I won’t go into how this is worked out. As it is complex enough just for the simple moving average but if you go into algorithms on weighting new data as to that of old, then that would cover a whole book in itself.
All you need to know is that we use both the SMA and the EMA as they work well together to signal Open and Close points within a chart. I have yet to find a moving average formula that works as well as these two combined in a system.
Configuring the Moving Average:
I am now going to show you how to configure the four moving average values for the moving averages (MA). If possible, use a service or software that allows you to have the above moving averages colour coded. Each MA is used to signal either an Opening or Closing position (Long or Short) and our Moving Stop Loss, as well as a general long term moving average.
The moving average settings in most programs are available by right clicking on the mouse whilst on the chart.
On the online services, they vary, there will either be an options setting or the MA can be selected from a simple menu. For me to cover the actual selection process to configure an MA would be too vast. As I’ve said before, select a program or service that allows you to at least configure the MA and select three or four differing types that can be shown at the same time.
Please note that the following charts are in grey scale images, yet I refer to the lines by the colour that you set for them. The colour makes no difference as to how they work, obviously, and therefore you can select the style that you feel suits you. In each setup I state where the line appears AT ALL TIMES in any chart, therefore the relation to the colour is secondary.
Configuration Settings:
Red Line (this is the upper line on a rising trend and the bottom line on a falling trend) – Simple Moving Average – 20 days (keep all other settings).
Green Line (this is the middle line on either rising or falling markets) – Simple Moving Average – 40 days (keep all other settings).
Blue Line (this is the bottom line on a rising trend and the top line on a falling market) – Simple Moving Average – 60 days (keep all other settings).
Grey Dash Line (this line is the dashed line and will appear as the furthest from top of the above lines on a rising) – Exponential Moving Average 200 days (keep all other settings).
- *The 200 day moving average can be omitted. Institutions sometimes use this as a gauge for the stock. In fact there is one well known spread betting training, who has very expensive, highly marketed seminars – he uses this technique alone! What was it I said about expensive seminars….. ‘bah humbug’
- Please note that usually you should be able to change the above parameters so that we use only the one exponential moving average for the trailing stop (EMA 40) and the 20 day EMA is changed to a Simple Moving average. All this will do is add a small amount of lag to this moving average.
The above should show 4 lines across any chart. Similar to that of the example picture below.
Those of you who have these charts in monochrome, the easiest way to remember which line is which is that the Red line is uppermost on a rising trend and the bottom of a falling trend. The blue line is the uppermost on a falling trend and the lowest on a rising trend. The green middle line remains in the centre.
Obviously it depends on which chart you are showing, but as you can see. The moving averages now move independently from that of the data on the price line as well as independently of one another.
Also looking further, you may begin to see that the moving averages are actually showing you where trends are being formed. Take a while to examine how the moving averages predict price swings, how the Moving Stop Loss keeps within boundaries and when to open/close whenever you are going when or short.
I am deliberately not telling you which line is used for which I want you to guess before we move on. If you’ve been doing your homework and read everything carefully up to now, you should do this standing on your head. I will give you the answers on the following page.
Quiz:
What are the following lines used for?
Red Line is for Open – Close or Both?
Green Line is for Open – Close or Both?
Blue Line is for Open – Close or Both?
Grey Line is for Why the grey line?
Did you get it right?
Well before you find out, I want you to double check that you have the Moving Averages set up correctly as set out below. Or else you will be getting incorrect readings and this could cost you money.
So what we should have set up now is the following:
Chart = Log Scale
1 x Exponential Moving Averages 200 day
3 x Simple Moving Average 20 day 40 day 60 day
Moving Averages colour coded:
Red = 20 day Simple Moving Average
Green = 40 day Simple Moving Average
Grey = 200 day exponential Moving Average
Blue = 60 day Simple Moving Average
All the above should be displayed at the same time on your chosen chart application or service. Which should show lines that converge and vary as they follow the ebb and flow of the chart line.
Now for the results of the quiz. For me to give you the answers, I need to go into detail, as part of our system works on signals produced by these moving averages as well as key visual signals we look out for, which I will tell you about in the next few pages. Plus the same lines mean differing things depending upon the trend that is apparent in the chart.
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