In the previous post of this series I discussed what a Moving Average is and how it’s calculated.  Now let’s get to the good stuff and talk about how to trade using it.

The first way we’ll discuss is to simply view the moving average as a general trend direction indicator.  This is one of the very first methods of MA trading to become popular.  With this method the trader compares the current price to the Moving Average trace to see which is higher.  Because the Moving Average lags behind the price (see the previous post) it will always be below the price during times when the price is rising (an up trend) and it will always be above the price during times when the price is falling (a down trend).  That’s the basic principle, but there are some other things to consider.

First, you need to be sure that you’re trading trends that are longer than the period of your Moving Average by at least a factor of two.  For instance, if you are using a Moving Average that is calculated using the most recent 20 bars (Period = 20) you need to be looking for trending moves that will last at least 40 bars.  Shorter moves than that will not be detected by the Moving Average because it’s filtering them out – remember that a Moving Average smooths out rapid price movements to expose the longer term trends.

Second, you must have a clear idea of what it means to say that the price is ‘above the Moving Average’ or below it.  Most traders use the Close price of the bar as their point of comparison, but others use measures such as the average price ((Close + Open + High + Low) / 4) or the midrange price ((High + Low) / 2).  Pick the price value you wish to work with and stick to it.  Then consider that short term, spiky movements can make the price jump back and forth across the Moving Average trace instead of clearly crossing it in one direction or another.  Try to develop a rule for determining when the price has truly crossed the Moving Average trace – such as requiring the an entire bar is on one side or the other, or waiting until the Close price is at least X pips beyond the MA line.

Third, you must consider the slope of the price line, that is, how steeply it is moving up or down.  As a general rule, you should prefer to trade when the price is moving more steeply, as this will often indicate a strong, rather than a weak and uncertain trend.

Then finally bear in mind that the best time to catch a trend is early, so if the price crossed the MA many bars ago, you may have missed most or all of the movement, and you should consider waiting until the next crossing.

Watching to see which side of the MA trace the price is on has been a winning strategy for over 100 years, but it must be applied intelligently, and as always, with a healthy dose of good money management.