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THERE is no such thing as a magic moving average number. How do we know? We’ve tried them all. (That’s how we know geeky stuff like Metatrader’s maximum permissible moving average period is 4000…)

Ready for the “duh” moment? Here it is:

The secret of moving averages is knowing what you are using them for.

The weaknesses of every moving average:

1. They look GREAT in trending markets, and do horribly in sideways markets. Try it yourself – buy when price crosses above any moving average and sell when it goes below. Chances are, you will give back a good chunk of your winnings when price goes into sideways markets.

2. They don’t really represent anything except a measure of where price has been in the last n periods. 

In short, the REAL use of moving averages is for us to deduce the amount of overall momentum currently in the market. A market that runs away from the moving average is trending (you could see THAT without the moving average anyway, as pure price action analysts like to point out). A market that is dancing around its average is consolidating or choppy.

Hang on a minute…doesn’t it matter which moving average?

Nope. Not at all. Different moving averages will have different sensitivities. A faster one will pick up trends earlier. A slower one will get in later. You may think that means that the slower one is more “stable”. In a sense it is, but really if you think about it, that slower moving average is simply going to get chopped up when the market goes sideways in a large range. Bottom line: Sooner or later every moving average gets chopped. Deal with it.

So where does that leave us?

Having said that there is no magical moving average number, one useful one is 20. It can be the EMA, SMA, whatever. Trading gurus never tire of trumpeting the magical and potent properties of the 20 as support and resistance. We like it for a number of more practical reasons:

1. It follows the movement of price closely enough to give regular information regarding the trend. As shorthand, the 20 EMA pointing down indicates a downtrend. When it points up, it’s an uptrend, and when it goes sideways, it’s a sideways market. What about all the jiggling up and down in odd places in a sideways market? That’s the weakness of ALL moving averages – see above. And incidentally, any number between roughly 15 and 40 will do the same job. It’s a matter of which your eye prefers.

2. Thanks to the aforementioned trading gurus, many traders watch this moving average on every timeframe. It’s useful to know where they are going to place their orders before deciding if we agree or disagree with them.

Clearly, there is a lot more to the nuances of moving averages, but for the moment it suffices to say that most traders, even price action traders, like to have at least one average on the chart to guide their eye in making momentum and trend judgements.

With best wishes for your trading,

Kaye Lee
Private Fund Trader/Head Trader Consultant
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