How and why to use moving averages as dynamic support & resistance
We all know about the importance of horizontal levels of support and resistance … and why we draw on trend lines. But why would moving averages help us here? Moving average is just an average of closing prices over recent days – what logic tells us that it will have a magical effect on price turning points?
One look at these charts will convince you that these are worth paying attention to, and when you understand why and how they work, they can have a powerful effect on your profits …
The reason that moving averages are so powerful as support and resistance levels all comes down to peer pressure.
I would estimate that 90% of traders are using at least one of these five moving averages on their charts: 10, 20, 50, 100 or 200.
Take a look at these five moving averages plotted on an hourly forex chart:
It’s hard to ignore how often the price skims these lines before bouncing back. Something is going on when the price moves close to these levels – and that’s down to the number of traders who are watching these levels and acting on them.
Which is why you should be watching them too.
Which moving average is best?
As you can see in the chart above, sometimes the price bounces on the 10-period MA … sometimes on the 20 … the 50 … the 100 … and even occasionally at the 200 …
So how do we know which one to use?
Here are 3 approximations:
- The shorter your trading period, the shorter the moving average you should be looking at.
- The more strongly the market is trending, the shorter the moving average it will bounce from.
- The longer the moving average, the more reliable it is, but the slower its reactions.
6 tricks for using moving averages as support/resistance levels
The question we ask ourselves at any support and resistance level is – is this a bounce or a breakout?
Moving average support and resistance aren’t as powerful as horizontal levels, but they have the beauty of always being at hand, even if the market price is moving in uncharted territory.
So, how do we read price behaviour at these key levels? And how to we judge the strength of the signal we’re getting?
1. The pullback to the 50MA
This is a 1hr GBPUSD chart, showing a 20MA and 50MA.
After the moving average crossover, we get a pullback to the 50MA – this is a great test of the move, and our price then crosses back over the 20MA and shoots downwards.
2. Adding the 200MA
The 200 MA isn’t touched often, but when the price nears this, traders sit up and take notice. It’s not a moving average for traders who like to nip in for fast profits – it’s a slow, lumbering beast of a signal, but can’t be beaten for reliability.
If the price is above the 200MA, it suggests it’s in an uptrend, but when it starts moving back towards the 200MA, we are forming a ceiling on that trend.
Likewise, if it’s below the 200MA, trending downwards, but starts to move back up to the 200MA, it warns us that a reversal may be imminent.
So, going back to the 20MA and 50MA pullback … we can strengthen the power of this signal by waiting for the price to cross the 200MA for confirmation of a bounce.
3. The reversal danger zone
As we’ve seen, the price rarely bounces neatly, again and again from the same moving average. Instead of expecting this kind of behaviour – and being disappointed – it’s more effective to create a support or resistance “zone” between two moving averages.
Again, this uses the 20 and 50 lines …
When the price moves into the “danger zone” between the 20MA and 50MA, it flags up to us – questions we might be asking are:
- Is this a reversal about to happen?
- Should I hedge my position until we’re safely out of this danger zone?
- Is this a pullback, where I can add to my position, or buy back into a market as soon as we move out of the zone?
If you’re using a hedge following strategy, this is how you should be managing your positions, ensuring that you’re making the most from the market moves, and protecting yourself when it stalls.
4. Filtering out sideways markets
I could fill many, many pages with images of trending markets bouncing perfectly from a moving average, giving trend-following traders winning entry after winning entry.
But the problem with moving averages is that they really struggle when the market isn’t trending. A moving average in a sideways market can meander either side of the price – in fact, it acts more like a magnet for price action than a support or resistance level for it to bounce off.
The solution is to try to filter out these ‘duff’ periods, so we don’t risk our money on false signals. Not as easy a task as it sounds.
One method is to use the ADX indicator to warn us when the moving average is likely to be less reliable …
5. Price action
One of the most reliable ways to judge the efficacy of a support or resistance level is to watch price action around it.
Reading price action needn’t be tricky – there are a handful of candlesticks that are worth recognizing. If you’re not yet familiar with them, I recommend that you download the free Trader’s Bulletin guide, which will give you all the info you need.
6. Moving stop levels
A clear bounce from a moving average gives us a good signal to move up a stop level in a trend-following trade.
I’ve always struggled to have success with automated trailing stops, but this kind of intelligent tightening of stops is a great way to lock in profits.
Using Moving Averages in your trading
As with any support and resistance level, moving averages only act as flags – telling us to watch carefully what’s happening at these key levels, and to be on the lookout for other signals.
By adding these to your charts, you’ll also have extra in-trade information, helping to manage your trades and maximize profits.