As a CFD trader, it is crucial to use one or more indicators to help determine when to enter or exit a given market. The Moving Average is one of the simple and commonly used strategies for making trading decisions. This strategy involves using moving averages to identify trends and potential entry and exit points in a given market, given that a backtest supports the hypothesis.
In this article, we will delve into the details of using the moving average trading strategy with CFD trading. We will explore the benefits of this strategy, its limitations, the different types you can implement, how it works with CFD trading, and more. But first, let’s share some basics about the moving average strategy to get everyone up to speed.
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Overview of Moving Average
A moving average (MA) is a widely used indicator in the field of technical analysis. Its primary purpose is to smooth out price data over a specified time period by calculating a continually updated average price. This average is derived from the closing prices of a given financial asset over the chosen time frame.
Importance of Moving Average in Trading
The use of the moving average as a trading indicator has several important benefits, including;
- Identifying Trends: One of the key advantages of the moving average is its ability to help traders recognize and understand market trends. By plotting the moving average on a price chart, traders can easily observe whether an asset’s price is trending upward, downward, or moving sideways. A trend can easily be quantified into specific trading rules.
- Support and Resistance: Moving averages also serve as support and resistance levels. Traders can use them to identify potential price levels at which an asset might find support (bounces up) or resistance (reverses its direction).
- Measuring Momentum: Moving averages can be used to gauge the momentum of an asset. By examining the direction and steepness of the moving average line, traders can gain insights into the strength and sustainability of the asset’s price movement.
- Ease of Use: The moving average indicator is relatively simple to understand and implement, making it accessible to traders of various experience levels. Its straightforward calculation and interpretation make it a versatile tool for technical analysis.
- It has been around long enough: The moving average has a long history of over 100 years in technical analysis. Its longevity and enduring popularity are a clear sign of its effectiveness and relevance in analyzing financial markets over time.
Types of Moving Averages
Below are the most common moving average types and strategies:
Simple Moving Average (SMA)
A Simple Moving Average (SMA) is a basic calculation of the average price of an asset over a specified period. It continuously calculates the average for each new data point in the time series. The SMA provides a straightforward representation of historical price averages, making it useful for identifying general trends in an asset’s price movement.
Exponential Moving Average (EMA)
The Exponential Moving Average (EMA) is another type of moving average indicator that places greater weight on the most recent data points. It is similar to the SMA in measuring trend direction over a period but gives more significance to recent data. The EMA follows prices more closely than an SMA since it assigns higher importance to recent price data. It aims to highlight the current trend in the asset’s price.
Moving Average Crossover
Crossovers are fundamental moving average strategies. One common type is a price crossover, which occurs when the asset’s price crosses above or below a moving average, signalling a potential change in trend.
A moving average crossover involves the shorter-term (fast) moving average crossing above or below the longer-term (slow) moving average. This crossover can help traders identify trend patterns, potential entry points, and potential trend reversals.
Moving Average Ribbon Strategy
The Moving Average Ribbon Strategy involves plotting a series of moving averages of varying lengths on the same chart, creating a ribbon-like indicator. Traders use the distance between these moving averages to gauge the strength of a trend. The ribbon can help identify key support or resistance levels by assessing the relationship between the price and the ribbon. It can also signal potential trend changes when the price moves through the ribbon or when different segments of the ribbon cross each other.
Using Moving Averages in CFD Trading
You can utilize moving averages when trading CFDs:
Using Moving Averages for Technical Analysis
Moving averages are widely used indicators in technical analysis. They help traders analyze price trends and make informed trading decisions. By calculating the average price of an asset over a specified time frame, moving averages smooth out price fluctuations and provide valuable insights into an asset’s historical price behaviour. Traders can use the different types of moving averages, including Simple Moving Averages (SMA) and Exponential Moving Averages (EMA), to assess trend direction, identify support and resistance levels, and signal potential changes in market trends.
Calculating a Moving Average
The process of calculating the Moving Average depends on the type you intend to use. Let’s explore how to calculate both simple and exponential moving averages.
Simple Moving Average (SMA) calculation
The Simple Moving Average (SMA) is a basic technical indicator calculated by summing the recent data points within a specified period and then dividing the total by the number of periods. It’s a backward-looking indicator that relies on past price data.
Formula: SMA = (A1 + A2 + … + An) / n, where n is the number of days and As are the closing prices on the different days.
Exponential Moving Average (EMA)
The Exponential Moving Average (EMA) gives more weight to recent price points, making it more responsive to recent data.
It is calculated in three steps:
Step 1: Calculating the SMA for the chosen period
Use the SMA formula shared above
Step 2: Determining the multiplier using the formula
Multiplier = [2 / (Selected Time Period (days) + 1)].
Step 3: Calculating the current EMA
Current EMA = [Closing Price – EMA (Previous Time Period)] x Multiplier + EMA (Previous Time Period).
The below chart shows both a 25-day SMA and EMA (blue line):
As you can see, the EMA responds much faster than the SMA!
Trading Strategies with Moving Averages
Some of the common trading strategies with moving averages include the following;
Moving Average Ribbon Trading Strategy (sometimes called Guppy multiple moving average)
The moving average ribbon strategy utilizes a series of exponential moving averages (EMAs) with varying timeframes, all plotted on the same chart.
The ribbon provides insights into trend direction and strength, with a wider ribbon indicating a strong trend. Trading signals are generated based on moving average crossovers, similar to other strategies. The ribbon strategy is effective for identifying trend transitions in either direction, especially after a period of range-bound trading.
Moving Average Envelopes Trading Strategy
Moving average envelopes involve placing percentage-based bands above and below a chosen moving average. These bands can be set at different distances from the moving average. Traders often use this strategy between 10 to 100 days and watch for price interactions with the envelope bands. For example, in an uptrend, they may look to buy when the price approaches the middle band (MA) and starts to rally off it.
Moving Average Convergence Divergence (MACD) Trading Strategy
The MACD is a popular momentum indicator that measures the difference between two EMAs, often over a 12-period and a 26-period EMA, along with a signal line, typically a 9-period EMA. Trading signals are based on MACD and signal line crossovers. Traders buy when the MACD crosses above the signal line in an uptrend and sell short when it crosses below the signal line in a downtrend.
Guppy Multiple Moving Average (GMMA) Trading Strategy
With this strategy, two sets of EMAs are used, with the first set representing short-term trader sentiment and direction (less than ten days) and the second set reflecting longer-term investor activity (over 30 days). Trading signals occur when the shorter-term EMAs cross above or below the longer-term EMAs, indicating a potential trend change. GMMA is useful for identifying shifts in trend direction and can be customized by adjusting the EMAs’ timeframes based on market conditions.
Trading with Moving Averages
Before explaining how to day trade with moving average, it is crucial to understand these two terms: Golden Cross and Death Cross.
The golden cross is a bullish signal in technical analysis, marked by a short-term moving average crossing above a significant long-term moving average. It is widely seen as a strong indicator of a market’s impending upward trend. This is usually considered a good time to buy (in the stock market). Please see the linked article and the backtests we did there.
A death cross is a bearish signal in technical analysis, occurring when a short-term moving average crosses below a major long-term moving average, indicating an imminent downward trend in the market. This is considered the opposite of the Golden Cross and is seen as a significant market downturn signal by analysts and traders. This is considered a good time to sell, as clearly illustrated in the graph below. Please also see our backtests in the linked article.
Moving averages, specifically the Simple Moving Average (SMA) or Exponential Moving Average (EMA), play a crucial role in this approach. Traders use these averages to analyze short-term price movements and identify potential entry and exit points within a single trading session. For instance, they might use a short-term SMA or EMA (e.g., 9 or 21 periods) to closely track the price trend, but 50 and 200 are more frequently used.
When the fast-moving average crosses above the slow-moving average, known as a “Golden Cross,” it can signal a potential upward trend, prompting a buy order. On the other hand, when the fast average crosses below the slow one, called a “Death Cross,” it can indicate a downward trend, prompting a sell order. However, day traders must adjust the moving average periods and other parameters to align with the fast-paced nature of trading.
Using Moving Averages in CFD Trading
Moving averages can aid CFD traders in multiple ways. In CFD trading, traders often use moving averages to identify trends, support and resistance levels, and potential entry and exit points. The choice between using a Simple Moving Average (SMA) or an Exponential Moving Average (EMA) depends on the trader’s preferences and objectives.
SMAs provide a straightforward assessment of historical prices, while EMAs offer a more responsive view by giving greater weight to recent data. Traders should also consider different moving average strategies, such as crossover strategies and envelope strategies, to tailor their CFD trading approach to specific assets and market conditions.
Benefits and Limitations of Moving Average Strategy
Advantages of Using Moving Averages
- Data Smoothing: Moving averages smooth out daily price swings, making it easier to discern a stock’s overall trend. By reducing short-term volatility, they provide a clearer picture of whether a stock is trending upward or downward. However, it might also give many whipsaws when the market is not trading.
- Simplicity: Moving averages are straightforward analytical tools. If a stock’s current price is above a rising moving average, it indicates a short-term upward trend. Conversely, if the stock’s price is below a declining moving average, it signals a short-term downward trend. This simplicity makes it accessible to many investors.
- Ease of Calculation: Calculating a moving average is relatively simple, allowing the average investor to compute it independently.
Limitations of Moving Average Strategy
- Lack of Predictiveness: Moving averages, regardless of their type, are not predictive indicators. They rely on historical data and do not forecast future price movements. As such, they cannot definitively tell you what a given security will do next. Any backtest can aid or help you find out which assets are best for using moving averages.
- Lag: The responsiveness of a moving average depends on the period it covers. Shorter-term moving averages react more quickly to price changes, while longer-term ones are slower. A longer time frame can result in a significant lag in reflecting current market conditions.
- Difficulty with Price Volatility: Moving averages are less effective when prices are choppy or highly volatile, as they tend to move along with the price. This issue may be mitigated by using a longer time frame, but it can still persist.
- Equal Weighting with SMA: Simple moving averages assign equal weight to all prices, which can be a disadvantage when a stock’s price has recently made a significant shift. This may not fully capture the impact of recent price changes.
- Weighted Moving Averages limitation: While WMAs react more quickly to price swings, they can occasionally provide false signals due to their sensitivity to recent data. The weighting of recent data may lead to misleading trend indications.
- Whipsaws: The biggest limitation is whipsaws. When the market is directionless. it leads to many losing trades that can be both frustrating and unprofitable (losing money!).
Implementing a Moving Average Trading Strategy
Implementing a moving average trading strategy involves several key steps to effectively utilize these indicators in your trading approach.
Step 1: Setting Up Moving Averages
The first step is choosing the appropriate moving average type for your strategy. You can opt for Simple Moving Averages (SMA) for straightforward historical price averages or Exponential Moving Averages (EMA) to provide more weight to recent data. Determine the timeframe that aligns with your trading goals, whether it’s a short-term, medium-term, or long-term outlook. For instance, a 50-period EMA can capture a broader trend, while a 10-period EMA can focus on short-term movements.
Step 2: Identifying Trade Signals using Moving Averages
When the short-term moving average crosses above the long-term moving average, known as a “Golden Cross,” it signals a potential uptrend. On the other hand, a “Death Cross” occurs when the short-term moving average crosses below the long-term moving average, indicating a potential downtrend.
These crossovers serve as entry and exit signals. Additionally, traders monitor the relationship between the stock’s current price and the moving average. If the price is above an upward-trending moving average, it suggests a short-term upward trend, while a price below a downward-trending moving average indicates a short-term downward trend.
Step 3: Managing Risk
Risk management is a crucial component of any trading strategy. Stop-losses are often recommended, but they normally are detrimental to a strategy. We have covered this in a separate article about stop-losses.
Moving average trading strategies for CFD – backtests
At the end of the day, you need to test trading rules to find out if moving averages actually give a positive expectancy. You need to formulate trading rules and backtest those in a trading platform. We have already done this for you:
- 20 EMA Trading Strategy (SPY CFD)
- 50 EMA Trading Strategy (SPY CFD)
- 9 EMA Trading Strategy (SPY CFD)
Final Thoughts on Moving Average Trading Strategy
In summary, the moving average trading strategy can be a reliable approach for various types of trading, including CFD. However, it’s crucial to select the appropriate type of moving average and backtest it, as different types may produce varying results depending on the assets you are trading and the trading period. For example, an Exponential Moving Average (EMA) closely follows price movements as it assigns more significance to recent prices.
Additionally, it’s important to emphasize that using the moving average with other trading indicators can enhance the reliability of your trading signals.