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Magic of Moving Averages

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Trading Signals and systems

In technical analysis, the moving averages are used to identify buying and selling trading signals. Let us learn how?

What are the different signals that a moving average can give?

1. When price crosses Moving Average:

As we have already discussed, when the price of a stock crosses its Moving Average from below to up, it is a buy signal and when the price crosses the Average from up to down, it is a sell signal. However, we must remember that trading actions are always taken with a confluence of indicators. It should not solely depend on one such signal. We should use more indicators to filter out the best possible trades in the market. 

2. Crossovers:

There are triple and dual crossovers that are widely used in the markets. When a shorter-term moving average crosses a longer-term average from below, it is a buy signal.

Whereas, when a shorter-term moving average crosses a longer-term moving average from up to down, it is a sell signal.

The image below depicts the 13 - 30 day EMA crossover. It is very widely accepted and commonly used by traders in the market.

If you closely look at the above image, when the 13-Day EMA (blue line) crosses the 30-Day EMA (green line) from below to above, the price starts rising, whereas when the 30-Day EMA (green line) crosses the 13-Day EMA (blue line) from above to below, then you can see how the price started falling. 

Golden and Dead Cross: These are also moving average crossover systems.

A Golden Cross takes place when a 50 day moving average (short-term average)crosses the 200 day moving average (long-term average ) from below to up. The Golden Cross signifies a potential bullish rally in the stock. It specifies the change in the momentum of the stock and the stock may rally upwards. The basic psychology is that the shorter term moving average is crossing the longer term moving average. We must also remember to check volumes at the time of the crossovers for a better confirmation and filter of trades. 

The Dead Cross is exactly the opposite of a Golden Cross, where a 50 day moving average (short-term average) crosses the 200 day moving average (long-term average ) from up to down. The Dead Cross signals change in the momentum of the stock and the stock may fall down. The basic psychology is that the shorter term moving average is going below the longer term moving average - hence the change in momentum and possible trend reversal. 

3. Trend Order:

Trend Order is for people who are into intraday or short-term swing trading. To identify short-term trends, we can use a Triple Moving Average System, which includes 3 moving averages. We can use a 13, 20, and 30, or a 13, 21, and 34 set of moving averages. 

When the price of a stock is trading above all the three averages, it signifies that the trend order of the stock is up or the stock is in an uptrend. 

On the other hand, if the prices are trading below the three averages, it signifies that the trend order is down and the stock is in a short term downtrend. 

Long term traders and investors can use a combination of 30 , 50 , 100 or 34 , 55 , 89 period moving averages to understand longer term trends. 

4. 6,4 offset, High Low Band:

Moving Averages are not limited to just the closing prices of a stock. They can be calculated by using the High and Low Prices also.

Let us first understand the concept of displaced moving averages to understand this trading system better. 

A displaced moving average is any moving average  that has all its values shifted forward or backward in time. Normally we use positive displacement or shift the average forward in time to generate some trading signals. Traders choose to displace or offset the moving averages forward in time so that it better aligns with highs or lows in price, and depict a more precise picture of market dynamics. 

A displaced moving average is used in the same way as a traditional moving average. It helps to determine trend direction and order , helps forecast potential support and resistance areas and generate trading signals. 

Let us discuss a trading system that generates buy and sell signals, using displaced moving averages. We 1st plot the 6-day exponential moving average by using the data points as high and low prices, and move it forward by 4 periods ( we offset the indicator by 4 periods ).  So basically we will have a band of moving averages. 

The 6,4 offset trading signal says that in a trending market, a buy signal is generated,  when the price goes above the 6-period high (Blue line), and keep the low price (Orange line) as the stop-loss. 

A sell signal is generated when the price goes below the 6-period low (Orange line), and keep the high price (blue line) as the stop-loss. One should know that the 6,4 offset theory only works in a trending market. We should avoid the use of this trading system in a sideways market. 

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