How to understand the pulse of the market
Hello friends! Today let’s understand the importance of using the 20-day Moving Average while trading in any financial instrument. This is a very simple, yet effective tool to analyse price action. Depending on your style of trading you can choose a suitable time frame to apply the 20-day Moving Average.
The recommended time frames to apply the 20-day EMA are 60 minutes, if you are a day trader, daily if you are a swing trader, and weekly if you are a positional trader.
So how does the 20-day moving average help you as a trader?
Let us understand that in detail.
The 20-day Moving Average helps you in three ways:
- Helps you to ascertain the current trend of the underlying financial instrument
- Helps you to understand when the current trend is changing
- Because of the first two points, it helps you to know when to be a buyer & when to be a seller or when to stand aside.
A very simple rule that we follow while using the 20-day moving average is, if the current price is closing above the 20-day Moving Average & the Moving Average is clearly sloping up our underlying trend is up, if the current price is below the 20-day moving average & the Moving Average is clearly sloping down our underlying trend is down and lastly if the current price is trading around the 20-day moving average i.e if the 20-day moving average line is Flat we say our trend is sideways.
Let’s understand this point with the help of an illustration. Do note that this concept can be applied to any financial instrument that you are trading on. For example you can use the same 20-day moving average logic if you are trading crude oil or Gold, Silver or any currency.
Lets look at the following chart –
Presuming that we are swing traders and we are applying this 20-day moving average on the daily time frame, on our chart you can see that we have input the 20-day EMA. This EMA stands for Exponential Moving Average. Now friends, this will be too short a video to explain the difference between an exponential moving average and simple moving average, but to keep it simple, let us understand it this way. The exponential moving average gives importance to the recent price data and is more sensitive to price action, whereas a simple moving average gives equal weightage to all the data in the last 20 days. Since EMA is more price sensitive, for our analysis purpose, we use exponential moving average. However, there won’t be a huge difference if you either use a 20-day simple moving average or 20-day exponential moving average, but as a preference we always use exponential moving average which is popularly called EMA.
Coming back to Voltas , you can see that the stock moved above the exponential 20-day moving average on 1st September 2021, and thereafter continued its rally till mid of October. Now, post the stock closing above the 20-day exponential moving average at Rs. 1045 we saw almost a 30% rally in one month. In other words, the stock closing above the 20-day moving average on 1st Sept 2021 gave an indication of an upcoming rally.
Now, lets see what happened in Voltas from October 2021 to March 2022. We had multiple instances of the stock closing above & below the 20-day EMA. However, If you carefully observe the slope of the 20-day EMA, it was neither clearly up, nor clear down. It was more or less flat. This indicated a sideways trend for an extended period of time in stock. This is what happens after a strong uptrend. Stocks generally tend to go sideways before taking a directional bias again.
Post that period of consolidation, on 2nd May 2022 the stock again slipped below the 20-day EMA with a downward slope when the price was approximately Rs. 1200 post this, the stock extended the correction till about Rs. 920 levels!
Very recently, on 2nd Feb 2023, we had Voltas moving above the 20-day EMA with an upward pointing slope, when the price was Rs. 821. Post that, the stock has had a rally till Rs. 920 levels, and was still in a strong uptrend. A trader who is sitting long in Voltas can easily keep this 20-day EMA as stop loss & continue to hold his position.
Points to remember while using Moving Averages –
- Moving Averages are more effective on higher time frames like Daily, Weekly & Monthly & should be avoided on lower time frames like 5 mins, 15 mins, 30 mins, etc.
- Moving averages, tend to go a little haywire in a Sideways market trend. Thus, traders tend use them in combination with Support & Resistance, Pivot high & Pivot lows to reduce the amount of false signals in a sideways market & thereby enhance their effectiveness. But that’s a little bit of an advanced topic & we will take it up for discussion some other time.
For the time being, we hope you got some insight on how a simple tool like 20-day EMA helps us as a trader. Although it looks ridiculously simple, sometimes, as we all know in life, simple things prove to be the most effective. Do try and use this tool in your own trading and see the difference it makes.