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TECHNICAL ANALYSIS

Using moving averages to define the market trend and its strength

Technical analysis Moving averages

I believe there are three key components of successful trading and investing on the financial markets.  In this article, I will focus on one of these three important components, which is to trade and invest in alignment with the prevailing trend.

I cannot say which of these key components goes first. Actually I believe you cannot succeed without mastering each of these three factors.

The first major component of successful trading and investing is dealing with your emotions. Most people quickly lose confidence or start overtrading when they hit a losing streak. That’s a big topic and it requires a separate article only to introduce it correctly. Here I’d like to say that it is really important to learn how to deal with your emotions. You need to overcome your fears – mainly the fears of failure and fear of losing and fear of missing out as they will block you and will lead to self-sabotage. You also need to re-define your beliefs about what is possible. And you need to constantly be in a top physical and emotional state.

The second component of successful trading is money management. Most people do not know how to manage the size of their individual positions and the number of their positions. You need to clearly define what percentage of your capital you will invest and risk in each trade. And then you should be disciplined in following your own rules.

The third important component is to trade and invest in alignment with the prevailing market trend. This sounds like a no-brainer but yet many people go very often against the main trend for two main reasons: they either cannot define correctly the prevailing trend, or they deliberately try to catch the turning points. The first reason can lead to holding a long position during a strong downtrend and usually that happens when people enter it right after the trend has changed and they hope to see their position back to break-even. And we all know traders who want to trade the corrections, i.e. to catch the turning points. There are lots of strategies that try to catch those turning points. Usually when you are right, the reward is huge, as you have entered right at the top or right at the bottom. But the problem is you can’t be consistent in doing this as this is mostly guessing. You may be right one time and wrong ten times.

I personally know traders who are quite successful even with this kind of win/lose ratio because when they are right, they catch a big move. But it is very tough to trade that way psychologically as you may be on the wrong side of the trend for months in a row and then to be correct only for a couple of weeks before you enter another losing streak. So, I believe the best way to trade or invest is to always be positioned in line with the prevailing trends. This is the approach that most of the famous successful traders have followed. And in this article I will present a method that I have developed over the years that will allow you always to be positioned correctly with the market trend.

DEFINING THE PREVAILING TREND

How to properly define the prevailing market trend? You can follow different techniques to do that depending on your approach to the market. If you are a technician, you can look at the price pattern, the cycles, the Elliott Wave structure, many technical indicators, the key chart levels of support and resistance as well as Fibonacci pivot levels. Most of the traders and investors who follow the technical approach to the financial markets do a combination of all these. But usually you can define correctly the market trend using only a set of moving averages. And the best thing about it is that it is not only simple, but also very accurate. In the approach that I have developed define the trend comparing the position of the price to a given moving average and then I define the market strength comparing the price to another moving average.

First, we need to define the most important moving average based on the time frame that we trade. Depending to the time frame that you trade and the market that you trade you may find that the most important moving average is different for you. But I have found that for me the 100-period moving average works best. That means that if I trade on an hourly chart (with a time horizon of several hours to a few days), I will look at the 100-hour moving average, if I trade on a daily chart (with a time horizon of several weeks to a few months), I will look at the 100-day moving average and so on. Again, this may be different if you have a different time horizon and holding period.

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