The Moving Average has often been maligned as a lagging or look-back indicator. The knock on the MA is that by the time it signals a trade, the move might well be over or the trade far gone.
However, like most problems, there is a solution that can make the MA a prized asset in your trading arsenal once again.
The solution is to use the MA as an over/under indicator instead as a cross-over. The traditional way of using the MA is to plot two MAs of different lengths and take a signal when one crosses over the other – for example when the 5MA crosses over the 10MA.
A better way is to plot a single MA and use price as the signal to take a trade or not. For example if you plot a 5MA, you will only take a trade when price crosses the MA to the downside to go short and to the upside to go long.
This solution is not as simple to implement as it sounds because sometimes after a protracted move to one side away from the MA, it is actually time to reverse. The way to avoid being whipsawed on these moves is to use a Moving Average Envelope.
The MA envelope keeps you away from whip-saws by making sure that a sort of trend has developed before you join the trade. With an envelope, what you do is you set an upper and lower price threshold before you can trade. Your patience is rewarded by more winning trades using the MA Envelope.
This trading technique requires that you exhibit a lot of patience.
To build a MA Envelope, you are faced with making your first decision, and it is a crucial one. What MA setting do you use? Once you have made this decision, it is time to build the envelope.
Let’s build one that has proven to be very effective. To answer the first question, we will use the 8 period Moving Average or MA8, plotted on the 30-minute chart.
To build the MA8 Envelope, do the following:
%2B Plot MA 8, Smoothed, Apply to High, color yellow
%2B Plot MA 8, Smoothed, Apply to Low, color yellow
%2B Plot MA 8, Linear Weighted, Apply to Close, color red
There is your MA 8 Envelope.
As you look at your chart now, certain things start to become clearer to you as far as how the price interacts with the envelope.
You will start to notice why some trades that you had taken in the past fizzled and lost you money.
You make money when there is a north/south movement in price. Horizontal or east/west movement is called ‘churning’. It is ‘one yard and a cloud of dust’ as they describe in football, a play with little gain.
These then are the buy and sell rules:
%2B Buy when the candle closes above the MA 8 High
%2B Sell when the candle closes below the MA 8 Low.
The red linear-weighted MA8 plays a very important role in the envelope. It signals price exhaustion. When price is about to reverse or pull back, it moves closer to the left upper or lower corners of the two yellow smoothed Mas that make up the envelope.
In an uptrend, it gluiest itself to the upper left hand corner of the MA8 High, and in a downtrend, it glues itself to the lower left hand corner of the MA 8 Low.
When you see this phenomenon, prepare for either a pull back or a complete price reversal!
In the forex market or in any market that you trade, never trade without a stop loss! I can not over-emphasize this. You can not be 100% right so when you are wrong, save your account from being blown up.
With this envelope, there is a natural stop loss point provided to you. When you are long, use the MA8 Low as your stop and when short, use the MA8 High as your stop. A stop will qualify as a close under or over these averages.
To learn more about my techniques, please visit http://LEARNFOREXOPTION.COM and click on the Sample Lesson tab.
Olumuyiwa Ojo is a full-time spot forex and forex options trader. He writes about and researches techniques to make better trades.
Ojo lives in the Midwest.