Pioneering Moving Averages (Avoid False Signals)

Moving Averages Trading System with envelopes is the simplest way to identify opportunities and manage risk. 

1. This system is handy for positional traders investing in stocks for less than a year (Short-Term). 
2. It is helpful for long-term investors and Day Traders, depending on using the correct chart period and experience in trading. 
3. I recommend against using it for Index trading, such as Futures and Options on Nifty or Bank Nifty. Technical analysis is unsuitable for highly volatile securities like indices because indices are more susceptible to global events, and many Institutional players change their opinions instantly. 
4. If you are a Derivatives trader, better use derivatives tools like
   1. Open Interest 
   2. PCR 
   3. Max Pain. Etc. I will explain these in my upcoming video. 

Back to our topic. Pioneering Moving Averages With ADX. 

I will address the use case scenario of moving averages instead of explaining how to construct them. I will use the DLF daily chart to illustrate the use case scenario. 

I generally use a 14-day Exponential Moving Average as my fast-moving average and a 50-day Exponential Moving Average as my slow-moving average. 

Why 14 and 50? Generally, a 10-day moving average accounts for 2 weeks’ price action and a 20-day moving average accounts for almost a month. 

However, the 14-day moving average balances short-term responsiveness and medium-term trend identification. The 50-day moving average is crucial support and resistance for the short term, smoothing out short-term fluctuations. 

Why the Exponential Moving Average? The Exponential Moving Average helps avoid the drop-out effect caused by the Simple Moving Average. Exponential smoothing gives more weight to recent prices without ignoring older prices. 

Most successful traders use a 14-day fast-moving average for two reasons.

1. To generate Signals (Buy or Sell)
2. Trailing stop loss. 

The 50-day moving average is the slower one and is used as support and resistance for the short term. 

It’s all good. Most of us know that whenever the 14-Day moving average crosses above 50, it is a buy signal; whenever it crosses below 50, it is a sell signal. 

The Bigger challenge is signal failure; most traders, particularly new traders, get frustrated with signal failures. These are called Whipsaws, 

Yes, the moving average system fails and gives unreliable signals when prices are in a sideways market. If you trade every signal, your profit drawdowns are poorly affected. 

What’s the solution? The idea is to take advantage of those productive (trending) signals and avoid trading in sideways markets. 

One of the most preferred tools for identifying productive signals is using envelopes with average true range. 

Most stock brokers provide these two technical tools on their platforms freely. So you can make use of them. 

Building Moving Averages System Using Envelopes as Filters!

Step 1: On the Plain Daily chart of any stock or index, add the ATR (Average True Range) Indicator. This indicator tells you the average daily range of the stock prices.

The above chart shows that the ATR indicates the average true range of the DLF stock price is approximately 3%. Note this number, which is helpful in Step 2.

Step 2: Now, add the envelope indicator by clicking on the indicators tab on your trading platform. Most stock brokers, like Fyers and Zerodha, provide both Envelope and ATR indicators on their trading platforms. Instantly, the envelope indicator gets added to the chart with the default values; you need to change the default values, as shown in the graph below.

You can check in the graph that the length value is 50, and the Percentage is 3% as per the ATR indicator explained in Step 1 and tick Exponential. Thus, the overall indicator uses an exponential value, which avoids the drop-out effect.

Step 3: This is the final step of constructing the Moving Average Crossover System with Filter (Envelope Indicator). To do so, add a 14-day Exponential Moving average to the existing chart.

Once the above system is ready, observe the charts. The general thumb rule is:

1. Buy Signal: Whenever the 14-Day EMA crosses above the 50-Day EMA.
2. Sell Signal: Whenever the 14-Day EMA crosses below the 50-Day EMA.

According to the above rules, you will have many whipsaws or false signals when prices are in Sideways, that is, no proper trend either Up or Down. Check out the graph below, which shows the number of times prices failed to trend, even though there are buy and sell signals generated by the moving average system in sideways markets. These signals can poorly impact your profit drawdowns.

To avoid trading these signals, use new thumb rules:

1. Buy Signal: When the 14-Day EMA crosses above both the 50-Day EMA and the Upper Band of the envelope.
2. Sell Signal: When the 14-Day EMA crosses below both the 50-Day EMA and the Lower Band of the envelope.

Following the above rules, you will focus only on productive signals to help you identify potential stock price trends. The system’s accuracy depends on your observation of the chart and the ATR indicator percentage. If you are a conservative trader, use the recent high of the ATR indicator. If you are a risk taker, use the recent low value or the value that suits your trading.

I generally prefer higher ATR values to avoid stock price volatility, and I will use the 14-Day EMA as a reference to place the trailing stop loss. If I can capture a potential trend utilising this system, I will put a trailing stop loss just below the 14-day Moving average whenever prices deviate from the 14-day EMA.

I hope you enjoyed the content! 😊 If you have any feedback, please mention it in the comments section below.