Day trading is a fast-paced form of trading that is based around placing several trades a day and accumulating several small gains. Realistic gains made from individual trades when day trading are small, in comparison with trading on longer term time frames, therefore optimal entry and exit points are essential so that nothing is left on the table.
To assist with identifying entry points, traders turn to technical indicators like moving averages, to pinpoint the perfect market entry price level. There are two forms of moving average, the Simple Moving Average (SMA) and the Exponential Moving average (EMA). The EMA is sometimes preferred to the SMA as it gives additional weighting to more recent price points and reacts quicker to current market sentiment.
Whichever version of the Moving Average indicator is chosen, it must be configured to suit the needs of the day trader. This article discusses the best moving averages for day trading.
In This Article
- What Is Day Trading
- Understanding Moving Averages
- Best Moving Averages For Day Trading
- Using Moving Average Indicators To Day Trade
- Protecting Your Position
- Summary
What Is Day Trading
Each trader will have their own trading style, and each will happily argue the benefits of their chosen strategy over any other, the truth is that there is no trading style that will suit everybody! To determine a trading style that suits you, it is highly recommended that time is set aside to develop a trading plan. This will help highlight what is looking to be achieved, levels of risk that are prepared to be taken and importantly, how much time can be dedicated to trading.
When drafting a trading plan, it should become clear whether day trading is a suitable form of trading or not. If you are looking for a trading strategy that infrequently requires attention and brings large gains, day trading is not for you. The fundamental principle behind day trading is that trades are entered into on a daily basis, and perhaps several of them per day, and positions closed before session end.
Whilst day trading requires short term trades with lower pip gain potential, there a few variations:
Range Trading - This is a strategy that is based on support and resistance. Attention is placed on historical key price points that act as a signal for a price reversal.
Scalping - This is the most aggressive form of day trading. Close attention is paid to the small price fluctuations and positions are held for perhaps only minutes at a time.
News - This requires following the economic calendar and keeping an eye on economic announcements. Announcements about a countries employment level, production, interest rates etc can cause volatility in a currencies value. This form of trading looks to capitalise on the price movement that occurs immediately following the announcements.
Understanding Moving Averages
Moving Averages are one of the most commonly used technical indicators by experienced traders. A Moving Average takes a set number of periods and accumulates their closing prices, the average closing price is then overlaid the current price on the technical chart. The purpose of a moving average indicator is to remove market noise that can make identifying trends, particularly on small time frame charts, quite difficult.
There are two forms of moving average indicator, the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). The EMA differs from the SMA by attributing more weight to the more recent closing prices, the idea being that the later prices are a better indicator of current market sentiment than historical prices.
Both indicators are classed as lagging indicators as they react following current price action. It is argued that the EMA is a superior indicator as it reacts quicker to current market sentiment. In this article assume we are working with the SMA.
Best Moving Averages For Day Trading
This is a question that is frequently asked by new traders and the honest answer is that it is completely subjective. What is generally agreed when using Moving Averages to day trade is that using three moving averages set over different periods will provide more reliable entry signals. The three moving averages that are more commonly used by day traders are as follows:
5 Period SMA - this is the short-term trend indicator and captures current market sentiment, calculated over only 5 time periods it reacts quickly to changes in momentum. When employing this strategy, we are always looking for the 5 Period SMA to be either the highest indicator in a bull trend or the lowest in a bear trend.
8 Period SMA - this is the medium-term trend indicator and should always be located between the 5 Period and 13 Period SMA before a trade is placed.
13 Period SMA - calculated over the longest time period the 13SMA is the long-term trend. In a bull market this should always be at the bottom of the three indicators and at the top in a bear market.
Using Moving Average Indicators To Day Trade
Now that we understand the concept of day trading and the workings and purpose of the moving average indicators, let's move onto how moving averages work in practice:
When we are using three moving average indictors to determine an entry point, we are looking for the lines to cross in order. Looking at the EUR/USD 5min technical chart above we have highlighted a perfect entry point that is signalled by a "Death Cross", a point where the long-term trend is crossed by the two shorter trends and are in order. The 5 period SMA is the quickest to react to current market sentiment and dives to a lower price point, quickly followed by the 8 period SMA and the longer-term trend follows behind them.
It is clear that if a trade was opened at the time of signal, there were significant gains to be had over only a period of 8 candles (40minutes).
The pattern would be reversed in the instance of a bullish market, a trader would react to a "Golden Cross" and all three indicators would move in order in an uptrend formation.
Protecting Your Position
It is important to remember that although all of the above sounds very promising, the moving average indicator is a lagging indicator, based in historical information and is no guarantee of future price movement. For this reason, it is strongly recommended that stop loss orders are religiously placed when entering a trade. A tightly placed stop loss order mitigates a losing trade and protect your other gains from being overwhelmed by one out of control losing trade.
It is generally accepted good practice to place a stop loss on the previous swing high or low.
Summary
A day trading strategy requires several trades to be placed over the course of day, each trade capitalising on the smallest fluctuations in price movement. In order to extract profits from the trades and leave nothing behind, identifying optimal entry positions is essential. Using technical indicators like moving averages can help, using multiple SMA's to compare current market sentiment to longer term trends can be an even more powerful tool. Utilising this strategy is not fool proof and placing stop loss orders to mitigate losses is essential to avoid wiping out gains from other trades.
