Generating Signals

As explained in the introduction, the moving average is plotted in a graph with the day’s price action. The following is a basic example of how to use the moving average to generate a buy or sell signal.

• When the closing price crosses and moves above the moving average, a buy signal is generated.
• When the closing price moves below the moving average a sell signal is generated.
• For added confirmation, some traders like to see the moving average line itself turn in the direction of the price crossing.

Periods and Sensitivity

The strength of the moving average is its versatility. A trader can choose which measure (minutes, hours, days, weeks), how many periods he wants, and which type of prices to select (closing, high/low, or a midpoint). This versatility is helpful when deciding which period to use.

Short term moving averages (10 period) will hug the daily price action line more closely than a long term (200 period) average. A sensitivite moving average is good because it can spot trend signals faster than using a longer term moving average. Extra sensitivity will also cause more trades to occur, risking higher transaction costs and may fall prey to “whipsaws”.

Longer averages help avoid whipsaws, but are slower to pick up on trends and especially reversals. If a trend stays in force a longer term moving average is better, but because it averages in more past data, it cannot reverse itself as fast as a shorter moving average and it may be slow to recognize the change. The job of the trader is to find a moving average that is sensitive enough to pick up the movement in the trends but is insensitive enough to avoid catching unnecessary “noise.”

Here is a breakdown of some trend lengths and the period one should use in a moving average to study them.

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