There are multiple ways of determining a trend but one of the most convenient is using moving averages.
Moving averages are simple to calculate and, therefore, simple to understand. The one important factor you should always remember about them, is that they are a lagging indicator – they are based on past price action.
Some traders like to use exponential moving averages to try and minimise the lagging effect but this has its own issues. It gives greater weight to recent price action and, if there has been extreme turbulence in price recently, this can add to the confusion (rather than to help clarify).
It is therefore more straightforward to use simple moving averages but to be aware of the limitations.
In this article we will be looking at:
- Which moving averages give us the best indication of trend direction
- Moving averages as support/resistance
- Golden and death crosses
- Moving average alignment
The article will make the assumption that we are trend trading from a daily timeframe.
The 200 simple moving average
A commonly used moving average is the daily 200 simple moving average. It has been popular since technical analysis was in its infancy. It is easy to calculate, plot and interpret and does not move too fast or too slow in relation to current price.
It really is the mainstay of the moving average cohort. It should always be plotted on your daily charts. And, as a rule of thumb:
- If price is trading above the daily 200 line you should only look to buy
- If price is trading below the daily 200 line you should only look to sell
While the 200 line gives us a general bias (as to whether to look for long or short trading opportunities) it is generally too far from price to to apply any further significance.
So we need to look for another moving average which plays a little closer to price action.
The 50 simple moving average
The daily 50 simple moving average is another commonly used chart indicator. It only looks back 50 bars so will stay much closer to the current price.
In a good trend:
- Price should stay above the 50 line in an uptrend
- Price should stay below the 50 line in a downtrend
If the market is not trending then price will crisscross the 50 line (giving us a clear indication that we do not want to trade the chart).
During a good trend the 50 line should act as support (in an uptrend) or resistance (in a downtrend). Ideally price should stay a fair distance away but there will be times when price pulls back further than desired.
As with any other zone of support/resistance we cannot expect the 50 line to hold firm all the time – there may be minor breaches, especially at the beginning and towards the end of a trend. If the 50 line is breached look for further support/resistance levels in close proximity – as price may pullback towards these points before reversing. Look out for reversal/continuation chart and candlestick patterns at critical levels, too.
Golden and death crosses
A golden cross is where the shorter-term moving average crosses above the longer-term moving average.
A death cross is where the shorter-term moving average crosses below the longer-term moving average.
Using the two moving averages we have already discussed, a golden cross would be when the 50 line crosses above the 200 line. And a death cross would be when the 50 line crosses below the 200 line.
The moving averages can be any combination – not just the 50 and 200. It can be used on any type, such as exponential moving averages.
- A golden cross is so-called because an uptrend is more likely to develop
- A death cross is so-called because a downtrend is more likely to develop
It makes sense that near-term momentum is with the shorter-term moving average so, when it crosses a longer-term moving average, we would expect a trend to develop. However, this is dependent on the moving averages we are comparing.
If the two moving averages we are close to each other (e.g. 10 line and 20 line) they will crisscross frequently, even in a reasonable good trend. Even a fairly minor pullback could give a false signal that the trend is reversing.
And if the two moving averages are very far apart (e.g. 10 line and 200 line) they will only cross when price is almost upon the longer term moving average. We would not have any advance warning that the trend may be reversing.
Of course, most traders have other factors in their arsenal to help them anticipate a trend reversal. But in this article we are looking specifically at using moving averages to help us determine a trend. So we need our two moving averages to be in alignment.
Moving average alignment
The 50 line and 200 line are not two moving averages picked a random.
The 200 line has been an industry standard used by many traders as a ballpark of long-term strength or weakness.
The 50 line has also been commonly used as close enough to price action (to allow for the natural fluctuations of the market) yet also far enough away (not to be crisscrossed by price on a regular basis).
In order to determine the trend we need the following:
- For an uptrend the 50 line must be above the 200 line
- For a downtrend the 50 line must be below the 200 line
In addition to this we would ideally want both moving averages to be tilted in the direction of the trend. The sharper the clock angle, the faster the trend is likely to be (although be aware of the scale on your charts). This shows that momentum is with the trend.
The end of the trend
The end of a trend doesn’t necessarily occur as the reverse trend starts.
So if, for example, a chart had been in an uptrend for some time (with the 50 line above the 200 line) and then the 50 line crosses below the 200 line it is not necessarily the beginning of a bear trend.
A trend can be temporarily halted by a period of consolidation. During this time the 50 line and 200 line could remain flat and/or cross each other a number of times – without price making a decisive bull or bear move.
If price is in consolidation we do not want to trade it – so we wait for our alignment to reoccur and for the incline to be favourable to the direction of the new trend. The new trend could be a continuation of the old one – or a reversal.
When new to trading many people are happy to use the 50 line and 200 line to help them determine the trend. But, after a while, they feel they could get into a trade earlier if they use a lower moving average rather than the 50 line.
Defining the trend is not the same as trading it. I am not advocating taking a long position every time the 50 line crosses above the 200 line, or a short position every time the 50 line crosses below the 200 line. This article only covers determining the current trend direction.
It is extremely useful to have a logical, fact-based rule for identifying the trend. In technical trading we want to remove as much subjectivity as possible.
So now you have a rational way of determining the trend. You can use this as the basis of your trading plan and build on it to then identify precise entry and exit points.
Good trend trading…