A moving average reversal, trend and momentum based forex, stock index and commodities trading system

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Introduction to the first Moving Average Momentum Trading System Series

Introduction

This article is the first of three articles which develop a moving averages momentum trading system, and go through a worked example of a trade that uses multiple timeframes and a systematic approach to the system.

Objectives

Our objectives in this series of three article are:- to define a short term, medium term and long term trend using moving averages.

  • to interpret a reversal of the short term trend using a ‘warning system’.
  • to make a systematic reading of overall momentum and direction using two timeframes
  • to go through a workable trading plan using an example, with clear entry, trade management and exit criteria
  • to introduce indicators that can be used for confirmation of a trade setup
  • to introduce forecasting of viable target areas using bollinger bands and fibonacci confluence clusters

Structure of the series

This post, post one, introduces key concepts and identifies and analyzes a trade setup using a ‘matrix’.

Post two goes through the trade’s evolution from start to finish in simple terms.

Post three examines the trade management and forecasting aspect of the trade.

Moving Averages as Momentum Indicators

Moving averages can operate as useful indicators of market momentum.

Let us define the short term momentum by way of three moving averages, a three periods, five periods and eight periods moving average.

By period, we mean the time it takes for a full bar or candle to form on any time frame.

Using two timeframes

Let’s take the fifteen minute chart as the operational timeframe for the purposes of this article.

And we shall take the one hour chart as the upper timeframe for the purposes of verification.

Let us define the shortest term momentum by way of the exponential moving average (EMA), 3 periods, and using the close price in the calculation.This will plot an average that gives greater weight to the more recent closes.

Early warning system

The 3EMA will closely follow the market.Strong moves in a reversing direction will create an angular ‘shoulder joint’.

Strong moves in a given direction will create a strong unbroken line in a given direction.

The 5SMA will follow the price action more slowly, but faster than the 8SMA.

The short term trend

The 8SMA is our ‘crux of the short term trend’.In other words, its pointing towards 2pm or higher means we are in ‘uptrend mode’.Its pointing towards 4pm or lower means we are in ‘downtrend mode’.

This goes for both the M15 and the H1 charts.

Reading momentum mechanically

Let us take this further and say that:

  • When the 3EMA crosses the 5SMA from above to below, this is the first warning that the market trend may be moving from up to down.
  • When the 3EMA crosses the 8SMA from above to below, this is the second warning that the market trend may be moving from up to down.
  • When the 5SMA crosses the 8SMA, and the 8SMA is now turning down, this is the third warning, and the confirmation that the trend may have moved from up to down.And vice versa for down to uptrending market in the short term.
  • We have thereby defined by rules an uptrending market in the short term.

    The backbone of trend change

    For potential reversals back to the initial trend before the short term change, let us consider the 20SMA as a support/resistance, particularly when it is pointing in the direction of the longer term trend (2pm or 4pm).

    Thus the 20SMA is a filter for false short term trend changes, or alternatively, defines for us that a short term trend change is a correction, rather than a fuller trend change.Support and resistance – medium term trendFor medium term trend, let us consider firstly, whether the price is trading above or below, and secondly, the slope of the 50SMA.Let us consider the 40SMA as ‘pre-warning’ support/resistance.

    Long term trend

    For the long term trend, let us consider the 100SMA and 200SMA – what is their slope, their relationship to each other, and finally, the relation of the average to the current price.Finally, let us introduce a pair of Bollinger Bands, set at 20 periods for the 20SMA in the middle, and two standard deviations either side of the 20SMA to give the upper and lower bands.The Bollinger Bands, if flat, indicate a sideways trend from one side to the other.

    The Bollinger Bands, if sloping, give a price level to consider the market as overbought (look for our reversal) when considering the upper band, and vice versa for the lower band, also looking for our reversal warnings and confirmation.

    How to read a momentum based moving average strategy summary

    We now have a complete system for defining the momentum of the market using moving averages.We have a short term trend defined by the slope 8SMA, with warning guidance of a change indicated by the 3EMA and the 5SMA.Above the 8SMA, the price is in long mode.

    Below the 8SMA, the price is in short mode.

    Above the 20SMA, if the 20SMA is sloping up, we are still in long mode, but assuming a correction to the 20SMA, if the short term trend is indicating short.

    The 40SMA and 50SMA offer support and resistance and tell us the medium term trend.The 100SMA and 200SMA offer support and resistance and tell us the long term trend.We are using an operational and upper timeframe.

    Matrix of possibilities

    Let us consider a matrix of possibilities as to what we may be seeing on our charts in the following two example figures.

    Figure 1. NASDAQ cash index 15 Minute chart.

    NASDAQ M15 chart

    Figure 2. NASDAQ cash index 1 hourly chart.

    NASDAQ H1 chart

    Figure 3. Matrix of possibilities.

  • Slope refers to pointing up or down.
  • Price relation refers to whether price is trading above or below the average and to what extent.
  • Direction refers to confirmed up or downtrend, warning 1, warning 2, or warning 3.
  • Of course, the granularity here is crude, in fact binary, but fit for purpose for this article’s illustration.

    TIMEFRAME 3EMA 5SMA 8SMA 20SMA 40SMA 50SMA 100SMA 200SMA
    M15 – slope DN DN DN UP n/a UP DN DN
    H1 – slope DN UP UP FLAT n/a DN DN DN
    M15 – price relation DN DN DN UP n/a UP UP DN
    H1 – price relation DN DN UP UP n/a UP DN DN
    M15 – warnings (DN) (DN) (DN)
    H1 – warnings DN (UP) (UP)
    M15 – reversal DN
    H1 – reversal DN
    Bollinger band sideways or slanting – M15 UP
    Bollinger band sideways or slanting – H1 SIDE
    Bollinger band touch – M15 DN
    Bollinger band touch – H1 DN
    M15 – conclusion 14 DOWN signals; 5 UP signals = 73.6% down
    H1 – conclusion 11 DOWN signals; 7 UP signals + BBands Flat = 61.1% down
    OVERALL CONCLUSION / TRADE IDEA The crude bias is down and the M15 is offering a leading trade, established short term down momentum, with the H1 3EMA warning now in place. With the H1 Bollinger Bands being flat, the logical extension is to the lower Bollinger band on the H1 chart. At this point, due to the sideways nature indication, the lower time frames should be used to trail the stop according to swings (trade management 1), aiming for the 1:2.5 risk reward. Alternatively, 60% of the trade can be closed (trade management 2), with the stop then brought to breakeven, again aiming for the 2.5 risk reward. Or both management methods can be employed (e.g. Close 75% of the trade, trail the stop with the remaining 25%).

    Conclusion

    By utilising a number of moving average indicators, we can define the market’s trend context in the short, medium and long term, and identify changes by way of pre-defined rules based on a limited number of parameters.

    In the next articles, we will trace this trade through from start to finish.

    Coming soon... signals every day. Pepperstone Group Limited