Trading slip-ups with moving average indicator

Traders commonly use a moving average indicator to identify trends and potential areas of support and resistance in an asset. While moving averages seem straightforward, many traders commit avoidable mistakes that cause them to enter or exit trades at unfavourable prices.

This trading guide will explore some of the most common pitfalls when using a moving average in trading strategies and how to avoid making these mistakes yourself. Learn tips on customising moving average periods, combining signals, and more.

Mistake 1: Relying on just one moving average

Many beginner traders believe they can base a whole trading strategy around one moving average setting, such as the 50-day. However, relying on just one moving average in isolation can give false signals and often causes traders to miss the early signs of a trend reversal.

For example, if you went long when the price crossed above the 50-day MA, assuming it signalled an uptrend, you may get a shorter-term price action. The 50-day MA may continue trending up for some time, even during a corrective dip. If you relied solely on this one MA, you may not exit in time before incurring more losses.

A wiser approach is using the 50-day moving average together with the 200-day moving average for confirmation. If the 50-day MA crosses the 200-day MA, that helps confirm whether a potential new uptrend or downtrend is beginning. Using shorter and longer-term moving averages makes trading signals more reliable and reduces the chances of false alerts.

Mistake 2: Failing to customise moving average parameters

One of traders’ biggest mistakes is using generic off-the-shelf moving average periods without customising them. The standard settings like 50, 100 or 200-day moving averages may seem valid. However, a one-size-fits-all approach seldom works in trading. Markets are dynamic, and financial securities exhibit diverging volatility patterns. What works well for one stock may lead to underperformance in another.

Let’s compare a high-beta small-cap stock versus a blue-chip with modest price fluctuations to demonstrate. The small cap can surge or plunge 20-30% in a matter of weeks. The blue chip tends to grind higher with occasional corrections under 10% during market swoons. These two instruments trade differently. So, a moving average may succeed and fail in the other.

When it comes to highly volatile small-cap investments, relying solely on a 200-day moving average may not be effective. The reason is that much of the market movement has already occurred by the time it signals a trend change. This delay in response time could cause an investor to miss prime profit windows. On the other hand, stable blue-chip investments don’t require quickly adapting moving averages as their market movements are usually more predictable.

This demonstrates why customising moving average periods is essential based on the instrument. For the small-cap, consider shorter moving averages like 20 or 50 days to trade swings. Use higher periods of 100 or 200 days for stable large caps to ride durable uptrends. Failing to match moving averages to volatility profiles risks missed profit opportunities or premature signals.

In addition, keep assessing if your chosen moving average periods still fit the asset as market conditions evolve. For instance, adjust longer moving averages faster if volatility declines in the small-cap during market breaks. If the blue-chip grows more volatile, adapt shorter moving averages to remain sensitive to trend shifts.

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Mistake 3: Ignoring the slope of moving averages

While moving average crossovers undoubtedly offer useful insights, they also assess the slope or angle of MAs to gauge trend strength. Specifically, a steeper upward or downward slope implies solid momentum fueling the trend’s continuation. A flatter moving average suggests waning control where reversals become likelier.

For example, a strongly sloped 50-day MA reflects solid buying interest in control. Dips tend to get bought aggressively and are viewed as opportunities amid the uptrend. However, if the MA slope flattens despite a crossover, it indicates fading enthusiasm where would-be buyers remain sidelined. This reduces the chance of consolidation or a more profound correction rather than trend resumption.

Ignoring MA slope nuances provides an incomplete picture, potentially causing mistimed entries or exits. Combine slope analysis with moving average crossovers to improve profitable signals. This approach provides a more detailed and holistic view of market movements, allowing for more informed and sound decision-making.

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Mistake 4: Lacking a clearly defined exit strategy

A frequent trading mistake is entering signals based on moving average crossovers but lacking a structured exit strategy afterwards. Planning on where to take profits or cut losses is necessary for exit decisions to become arbitrary and emotionally driven.

For example, assume you bought a stock when its price exceeded the 50-day moving average, signalling a potential uptrend. However, you fail to project reasonable profit targets or downside risk limits for this trade. As the stock rallies higher, greed kicks in, hoping to maximise gains. You hold too long, giving back profits when the uptrend reverses.

Conversely, anxiety builds up if the trade moves against you after entry. You exit prematurely to avoid further losses based on panic instead of reason. The lack of deliberate exit rules in both cases hurts your bottom line due to emotional decision-making.

The solution requires designing smart exit systems to complement moving average entry tactics. For instance, set upside profit targets based on overbought RSI readings above 70. Or aim to secure returns near Fibonacci retracement levels of prior swings or breakouts. Also, define maximum acceptable losses upon entry based on recent price volatility or technical support areas.

Such confirmation indicators or volatility metrics to formulate exit rules favour trade outcomes. You preemptively eliminate greed and fear from decision equations through unemotional data-based frameworks. With moving averages dictating automated entries, concurrent exit systems reduce idle decision paralysis. The result is smoothly running trades and avoiding regrettable impulsive actions over time.

Mistake 5: Using too many moving averages

In an attempt to cover all bases, some traders clutter their charts with a maze of moving averages. They figure more moving averages lend greater signalling power and confirmation—however, an overkill of too many MAs results in confusion and decision paralysis.

For instance, a single chart shows simultaneous signals from the 20-day, 50-day, 100-day, and 200-day moving averages. Identifying reliable signs grows challenging with so much potentially contradictory information. You may get a bullish crossover on the 20-day MA while the other slower-moving averages deteriorate. Other times, the faster moving average whipsaws with false signals while slower MAs lag. With diverging inputs, deciding which signal deserves priority over others would avoid leading to analysis paralysis.

The optimal approach focuses on one to three complementary moving averages for the most precise signals. For example, combine a fast MA, like 20 or 50 days, to identify short-term trends with a slower 100 or 200-day MA for long-term insights. The limited mix of inputs offers ample confirmation without the clutter and noise.

Quality beats quantity when selecting appropriate moving averages. Identify the minimum blend of MAs that best suits your trading style based on volatility considerations. Overloading charts with an array of moving averages tends to cloud judgment instead of amplifying it.

The bottom line

Moving averages offer useful trend analysis but require customisation and planning to avoid common downfalls. Mistakes like using a single generic MA without confirmation lead to premature or false signals. Similarly, failing to define exit strategies in advance results in emotional decision-making. However, traders can optimise results by combining complementary moving averages, assessing slope directionality, and establishing data-based profit targets and stop losses.

Avoiding the five pitfalls outlined allows you to appropriately adapt these versatile indicators to stack probabilities in your favour. With the right foundation, moving averages can anchor trading strategies through various market cycles. So don’t just settle for basic moving average techniques. Keep innovating with custom settings and additional confirmations tailored to your trading style.

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