Okay, so in our last post Introduction to Day Trading Strategies, we talked about the different flavors of trading strategies out there. Now, let’s grab our forks and dig into a real classic, maybe the most fundamental approach of all: Trend Following. And we’ll focus on one of the most popular tools traders use to do it: Moving Averages (MAs).
The core idea behind trend following is dead simple: Identify the main direction the market is heading (the trend), jump aboard, and ride it until it shows clear signs of ending. Sounds easy, right? Well, the devil, as always, is in the details.
Think about it like surfing. You don’t create the wave; you wait for a good one to form, paddle hard to catch it, and then ride it as smoothly as possible. You try not to fall off (get stopped out by noise) and you get off before it crashes completely (the trend reverses). Moving averages can act like your surfboard and your guide to reading the wave.
What Exactly IS a Moving Average? (Quick Refresher)
Before we dive into strategies, let’s make sure we’re on the same page. Remember from the Beginner’s Guide [Link to Beginner’s Guide Post 17: Introduction to Basic Indicators]? A moving average simply calculates the average closing price of an asset over a specific number of periods (like days, hours, or minutes). It’s “moving” because as new price data comes in, the oldest data point drops off, and the average is recalculated, making the line move across your chart.
- Simple Moving Average (SMA): Just the basic average – adds up the closing prices for the last ‘X’ periods and divides by ‘X’. Gives equal weight to all prices in the period.
- Exponential Moving Average (EMA): Similar, but gives more weight to the most recent prices. This makes it react a bit quicker to price changes than an SMA of the same length.
Which one is “better”? Neither! They just behave differently. EMAs are faster; SMAs are smoother. Many strategies use one or both. For day trading, traders often lean towards EMAs because they react faster to intraday swings, but SMAs are still widely used. We’ll often talk about EMAs here, but you can experiment with SMAs too.
Common Day Trading MA Lengths: Traders often use a combination of shorter-term and longer-term MAs. Popular choices on intraday charts (like 5-minute or 15-minute charts) include:
- Short-term: 9-period EMA, 13-period EMA, 20-period EMA/SMA
- Medium-term: 50-period EMA/SMA
- Longer-term (for intraday context): 200-period EMA/SMA
These aren’t magic numbers! They’re just common starting points. The key is how you use them.
Using Moving Averages to Identify the Trend
This is the most basic use. How’s the wave looking?
- Slope: Is the MA generally pointing upwards? Suggests an uptrend. Is it pointing downwards? Suggests a downtrend. Is it flat or meandering sideways? Suggests a ranging market (where trend following probably won’t work well!). The steeper the slope, the stronger the trend is often considered.
- Price Location: Is the current price consistently trading above a key MA (like the 50 or 200)? Bullish signal – buyers are generally in control. Is price consistently trading below the MA? Bearish signal – sellers are dominating.
- MA Order (Stacking): Many traders look at multiple MAs. In a strong uptrend, you’ll often see the shorter-term MA (like the 9 EMA) above the medium-term MA (like the 20 EMA), which is above the longer-term MA (like the 50 EMA). They “stack” in bullish order. The opposite (50 above 20 above 9) suggests a strong downtrend. When they’re all tangled up and crossing each other frequently? Choppy market – danger zone for trend followers!
Rule #1 of MA Trend Following: Don’t try to force a trend trade if the MAs aren’t clearly showing you one! If they’re flat or tangled, step aside and wait. Trying to follow a non-existent trend is like trying to surf ripples in a pond.
Strategy 1: Moving Average Crossovers
Okay, this is probably the most well-known (and maybe over-simplified) MA strategy.
- The Concept: Use two MAs – one short-term (e.g., 9 EMA) and one slightly longer-term (e.g., 20 EMA).
- Bullish Signal (Potential Buy): When the shorter-term MA crosses UP through the longer-term MA. The idea is that short-term momentum is accelerating upwards, potentially starting or confirming an uptrend.
- Bearish Signal (Potential Sell/Short): When the shorter-term MA crosses DOWN through the longer-term MA. Short-term momentum is shifting downwards.
Sounds Simple, But Here’s the Catch (The BIG Catch):
MA crossovers are lagging indicators. They only signal a potential trend change after it’s already started. In strongly trending markets, this can work okay – you get in a bit late but still capture a good chunk of the move.
BUT… in choppy, sideways markets, crossovers generate a ton of false signals (whipsaws). The MAs cross up, you buy… then they immediately cross back down, stopping you out for a loss. Then they cross up again… rinse and repeat. It can grind your account down quickly.
Making Crossovers (Slightly) Better:
Because simple crossovers are often unreliable on their own, especially for day trading, traders usually add filters or confirmation rules:
- Longer-Term Trend Filter: Only take bullish crossovers (e.g., 9 EMA crossing above 20 EMA) if price is also above a much longer-term MA (like the 50 EMA or 200 EMA). This helps ensure you’re only trying to buy when the overall tide is rising. Vice-versa for sells (only take bearish crossovers if price is below the 50/200 EMA).
- Volume Confirmation: Does the crossover happen on a significant increase in volume? This can suggest stronger conviction behind the move.
- Candlestick Confirmation: Does the candle closing confirm the crossover show strength (e.g., a strong green candle on a bullish crossover)?
- Pullback Entry: Instead of buying immediately on the crossover, wait for the price to pull back slightly towards the MAs after the crossover and then look for an entry signal (like a bullish candle pattern) bouncing off the MAs. This can offer a better risk/reward entry. We’ll talk more about pullbacks next!
MA Crossover Example (with Filter):
- Setup: Price is trading above the 50 EMA (overall uptrend filter is met).
- Signal: The 9 EMA crosses above the 20 EMA on a strong volume candle.
- Potential Entry: Buy on the close of that candle, or wait for a small pullback to the 9 or 20 EMA.
- Stop Loss: Place it below a recent swing low or below the longer (20) EMA.
- Profit Target: Could be a fixed risk/reward multiple (e.g., 1:2 or 1:3 R/R, a key resistance level, or trailing the stop loss until the MAs cross back down.
Pros of Crossovers (with filters): Simple concept, clearly defined signals.
Cons: Lagging, prone to whipsaws in choppy markets even with filters.
Strategy 2: Using MAs as Dynamic Support & Resistance (Trading Pullbacks)
This is often considered a more robust way to use MAs for trend following. Instead of waiting for a crossover signal, you first identify an established trend (using MA slope and price location) and then look to enter when the price pulls back to touch or briefly dip below a key MA, treating that MA like a moving support (in an uptrend) or resistance (in a downtrend) level.
- The Concept: In a healthy uptrend, price often rallies up, pulls back to “test” a key moving average (like the 20 EMA or 50 EMA), finds buyers there (support), and then resumes the upward move. Downtrends are the mirror image.
- The Goal: Enter the trend at a better price (during the pullback) rather than chasing it after it’s already run up. Offers potentially better risk/reward.
How to Trade MA Pullbacks (Uptrend Example):
- Identify the Trend: Confirm price is consistently above upward-sloping key MAs (e.g., 20 EMA and 50 EMA, with 20 above 50). The trend looks healthy.
- Wait for the Pullback: Price has moved up and now starts to correct downwards, heading back towards one of the key MAs (let’s say the 20 EMA). Patience is crucial here! Don’t jump in just because it’s getting close.
- Look for Entry Signal at the MA: As price hits or slightly penetrates the 20 EMA, watch for signs that buyers are stepping back in. This could be:
- A bullish candlestick pattern (like a hammer, bullish engulfing).
- Price stalling at the MA and starting to curl back up.
- Sometimes looking at a lower timeframe (like a 1-minute chart if you’re trading off the 5-minute) can show the turn more clearly.
- Enter: Place your buy order as price confirms its intention to bounce off the MA (e.g., above the high of the bullish signal candle).
- Stop Loss: Place it definitively below the key MA and below the low of the pullback/signal candle. Gives it a bit of room but defines your risk clearly.
- Profit Target: Aim for a new high in the trend, a measured move based on the prior leg up, or a fixed R/R target (like 1:2 or 1:3). You could also trail your stop loss up below the MA as the trend continues.
Why This Often Works Better:
- You’re buying weakness within a confirmed uptrend (or selling strength in a downtrend).
- Often provides a clearer, lower-risk entry point than chasing strength or waiting for lagging crossovers.
- The MA acts as a logical area to look for support/resistance and place your stop loss against.
Potential Pitfalls:
- Sometimes price slices right through the MA and the trend fails. Your stop loss is essential!
- Price might not pull back neatly to the MA you’re watching; it might stop short or go to a longer-term MA instead. Requires some flexibility.
- You still need patience to wait for the pullback and the confirmation signal. Don’t just buy blindly because price touched the line.
Risk Management for MA Strategies
No matter the specific setup, risk management is KING:
- Stop Losses are Non-Negotiable: Always place a hard stop loss based on your strategy rules (e.g., below the MA, below the signal candle, below a recent swing low).
- Position Size Correctly: Calculate your size based on your stop loss distance and your predetermined risk per trade (e.g., 1% of account).
- Know Your R/R: Have a plan for taking profits that ideally gives you a better reward than your initial risk (aim for 1:1.5, 1:2, or more if possible).
- Beware Choppy Markets: Recognize when the MAs are flat or tangled. Trend following strategies perform poorly here. Maybe step aside or switch to a range-bound strategy during these times.
Final Thoughts: Keep it Simple, Be Consistent
Trend following with moving averages is a fundamental building block for many traders. Whether you use crossovers with filters or focus on pullback entries, the key principles are:
- Identify the dominant trend.
- Wait for a low-risk entry signal that aligns with that trend.
- Manage your risk rigorously.
- Be patient and disciplined.
Don’t get bogged down trying 50 different MA lengths or complex crossover combinations. Pick a couple of standard EMAs (like the 9, 20, 50), define clear rules for trend identification and entry signals (like pullbacks to the 20 EMA in a trend confirmed by the 50 EMA), write it down in your plan, and then practice executing it consistently. Track your results, learn what works for you in the markets you trade, and make small refinements over time.
This isn’t a magic bullet, but it’s a solid foundation for building a rule-based approach to trading with the trend.
- What’s Next? Pullbacks are a key concept in trend following. Let’s dive even deeper specifically into strategies for trading those dips within established trends.
