Moving Averages

by www.surefire-trading.com
Hi everyone, this is Ty Young with SurefireTrading.com.
In our last lesson, we found that Moving Averages are the building
blocks of the MACD: remember: Moving Average Convergence
Divergence; and as such, we find that they also can be useful tools
in confirming our entries.
There are two distinct ways that I make use of Moving Averages. One
is for higher time frames; such as, Daily, Weekly, and Monthly charts.
The other is for intra-day trading, which are the 1-min. through 4-hr.
charts. In this lesson, I will be discussing the latter.
But first Lets check out the preliminaries.
MAs are probably one of the most popular trading tools utilized by the
technical analyst, which are often broken down into several
categories; i.e., the Simple Moving Average (SMA), the Exponential
Moving Average (EMA), and the Weighted Moving Average (WMA).
And there are other deviations, such as the Double Exponential
Moving Average (DEMA). In fact, indicators such as Envelopes and
Bollinger Bands find their basis in the manipulating of Moving
Averages; however, since the two most popular Moving Averages are
the SMA and the EMA our lesson today will concentrate on the use of
these two.
Calculations
Calculating the average price of a particular asset over a specific time
period forms the Simple Moving Average.
Lets assume for a moment that we are trading the 15-min chart and
we decide to use a 3 SMA to aide in our decision-making. What
exactly is taking place? What precisely is the charting software
calculating behind the scenes? The software is adding the closing

prices of the present plus the past two (15-min.) time periods and
dividing the total by 3.very simple, huh? I guess thats why they
call it a Simple Moving Average.LOL.
As each new bar or candle appears, the most recent 3 candles are
used to recalculate the present SMA; discarding the closing price
that is farthest down the line. It looks like this:

1.5531 + 1.5529 + 1.5527 = 4.6587

4.6587 is then divided by 3 which equals 1.5529.
The 3 SMA line is then pinpointed by the software where the 1.5529
price registers on the chart.
Lets say the next candle closes at 1.5555. The initial price of 1.5531
would automatically be dropped from the calculation and the most
recent three candles would be recalculated to look like this:
1.5529 + 1.5527 + 1.5555 = 4.6611
The quotient of 1.5537 would then be plotted on the chart. The 3
SMA indicator would instantly move from the position of 1.5529 (as
previously calculated) to a position of 1.5537 (the present
calculation). Since 1.5537 is a greater number than 1.5529, the
charting software would interpret this calculation as a move in a
positive direction. It would then display the SMA as an upward
sloping line telling us that during the last 15-minutes the bulls
commanded the market.
As the market continues to move, every 15-minute period is
recalculated displaying a continuous line that visually provides us with
a means of determining who is dominating the market. As we can
plainly see on the chart below, despite the whipsawing movement of
the Moving Average, the indicator is clearly telling us that the bulls
are controlling the market.

Despite its usefulness, the SMA has a minor flaw (well, to some of us,
its not so minor) that is, its apparent delay in responding to price
action, which is why it is considered to be a lagging indicator. Even
though the EMA lags as well, by giving greater importance to the
most recent prices in its calculation than that which is attributed to the
earlier prices, we create an indicator that responds more quickly.

For you mathematicians, heres the formula:

EMA = [S * (C-P)] + P
S = Smoothing Factor
C = Current Closing Price
P = Previous Closing Price
The Formula for the Smoothing Factor is:

S = 2/(1+N)
N = Number of days for EMA
I dont know about you, but Im thankful I have charting software
doing my calculations.
Looking at the chart below, I have placed a 21 SMA (red) and a 21
EMA (blue) together to provide a comparison.

Practically speaking, though the EMA is calculated differently than the

SMA, as we can see, it is applied to the chart in the same manner as
to indicate the strength and weakness of the Bulls and the Bears.

Below, we see a chart with a 5 EMA of the High and a 5 EMA of the
Low providing us with an interesting channel depicting the current
trading range. Remind anybody of another indicator we recently
covered?

In addition to these configurations, there are as many combinations

that can be used when trading with Moving Averages, as there are
traders who use them. I recommend experimenting with many
variations to see which suits your trading style and the markets
traded.
Now, although Moving Averages can be manipulated in a variety of
ways, I will be using the Closing prices as opposed to the Highs,
Lows, or the Opens for our examples. And by understanding how
they respond to price, we begin to grasp the importance of such an
indicator as a stand-alone Trading System or more so - as a
confirming tool.
Deficiencies with Moving Averages
The most popular method of using Moving Averages is to position two
or more MAs, of different size with the intention of entering the market
as one crosses above the other. However, if traders understood

more of what the crossing represents, they would be less inclined to

use this tool in such a way.
And to make my point, I ask the question, Isnt the primary purpose
of utilizing any indicator to determine who is dominating the market?
The point at which two EMAs begin to cross depicts a balance of
power not domination. It is imperative that we interpret the
moving of these Averages in such a way as to inform us who is
beginning to take control of the market at any given time. In order to
accomplish this, we must wait for the MAs to develop a more
definitive signal.
Also, as stated earlier, another discrepancy found with the crossing of
Moving Averages is its lag-time. That is, by the time the EMAs have
reversed and completed crossing forming its sequential order, the
price has generally advanced significantly - even to the point of
reaching the shaded area, as in the chart below.

Now, in this example, this would not have been a big problem
because there was plenty of movement below the shaded area to
capture a small profit from the market (which is not always the case).
This leaves us with only one small (significant) problem the
Protective Stop (P/S). With such a delayed entry, had the market
gone against us, the loss would have been unnecessarily grave.
Notice the span between the entry and the previous high. I cannot
stress this enough, it is imperative that we wait for the EMAs to align
themselves in such a way as to decrease the gap between our entry
and our P/S.
This can be accomplished by one of two ways:
Strategy # 1 (conservative)
On the chart below, I have placed a 13 EMA (blue), a 21 EMA
(green), and a 60 EMA (red) of the closes providing us with three
entry opportunities.

As the EMAs begin to cross in a bullish manner, we have only the

beginning of the signal. Lets enlarge this chart and zero in on one of
these trades.

Lets walk through this trade together - once having

crossed, if we wait for the EMAs to:
begin to develop a sequential order (longer lengths to shorter
lengths)
begin to expand or move away from each other
begin to develop a significant slope (NOT Horizontal)
begin to retrace and break below any one of the EMAs (break
above in a bearish move)
subsequently rises and closes above the EMA that was
previously broken
while at the same time, if the two shorter EMAs are still in
alignment with the longest EMA
Enter long on the high of the candle that closed above the
EMA, which was broken (enter short if in bearish alignment)
Some of you may have noticed that we did not enter on the high of
the first candle that closed above the 60 EMA. Good observation.

We did not enter at that time because the following candle did not
break its previous high.

As we look at the example below, take note of the fact that we have
reduced our risk by shortening the distance between our entry and
our P/S. Had we entered after the initial cross (shaded area), we
would have increased our loss by thirty pts.

Click To Play The Video

Click To Play The Video

Lets look at some more examples.

On the chart below, an entry based on the crossing of the EMAs

would have positioned us so high in the market that we would have
easily been stopped out as one of our Protective Stops were
triggered.

And likewise with this chart below.

By now, it should be obvious to you that entering on an EMA cross,

though profitable at times, is not what I would consider a high
probability trade.
So, lets see what we have learned.
So far I have shown the mechanics of the EMAs in the lower time
frames; now lets add an indicator, the RSI, as a confirming tool. As
we take a look at the next four 60-min.charts, see if you can
determine why the shaded areas are high probability entries?

If youre thinking, Entered on the retracement, you are absolutely

correct.
And if you place your Protective Stops above/below the most recent
high/low, your Stops will be much closer to your entries, which will
minimize your loss if the market should move against you.
Now take a look (below) at the same coinciding areas but move up to
the 4-hr. chart. What do you notice about the position of the EMAs
and the RSI (or - use your favorite indicator for confirmation)?

In each case, the RSI was either on the appropriate side of the 50line or the RSI trend line had been broken or both. And the EMAs
were positioned with distinctive slope and sequential order.
However, did you notice how all three EMAs on the previous chart
(entry 4) had not come into full alignment? I will deal with that in
Moving Averages Part 2; check it out.
For SurefireTrading.com, this is Ty Young, reminding you to Read
the Charts.