A Guide to Trading Cryptocurrency Part 6: Moving Averages
Read Part 5 of BTCManager’s series, ‘A Guide to Trading Cryptocurrency,’ here. In Part 6, we look at an indicator that is straightforward and is a key metric many of the top financial analysts use in trading a range of assets.
In this guide, we introduce a trading technique that is commonly used and very easy to pick up; moving averages.
Many of the previous techniques outlined in BTCManager’s Trading Strategies have been quite complex. Here, we provide an overview of a trading technique that is more friendly to beginners and complements the Candlesticks and Fibonacci Analysis guide quite well.
The moving average eliminates noise from the price action by smoothing out the value of a cryptocurrency over a specified time period. For instance, stock traders use the 200- and 100-day moving averages to decypher the markets and obtain signals to buy and sell.
There are many ways to use the indicator, ranging from simple moving averages, exponential moving averages, and the Rainbow, which provides more of an in-depth look at the market, separating ‘traders’ and ‘investors.’
Moving Averages as Support and Resistance
Moving averages provide levels of support and resistance. If the price action is below a moving average, it is resistance; if the market is above a moving average, it should act as support. The more times a moving average has been tested historically, the stronger it is as resistance or support. Once we observe the price action closing above (or below) a moving average, we have a breakout, and we can expect the trend to continue as the resistance/support is broken.
Candlestick patterns can also be utilized to give stronger signals. For instance, if we observe a hammer candlestick near a moving average we expect to act as support, we can be fairly sure of entering into a long positions as compared to a test of the moving average with no discernible candlestick patterns.
This strategy is known as the golden cross, i.e., a crossover of two moving averages. The Golden cross is an invaluable technique, as it provides a buy (or sell) signal once the faster moving average crosses above (below), the slower moving average.
For instance, below we can see the example of a golden cross for ETC-BTC on the daily chart. Notice we use the 200 and 50 period moving average. These are the ones most commonly used by traders, along with the 100-period, but we could also use the indicator with Fibonacci numbers.
On April 4, 2017, the 50-day moving average crossed above the 200-day moving average for ETC-BTC, generating a buy signal. On that day, ETC-BTC closed at 0.00233695, and we should have entered into a long position here. Notice that prior to this date, the 50-day moving average was trending below the 200-day moving average, suggesting a downward trend. Now, when the golden crossover occurs, the market is indicated to be switching into an upward trend.
Now for some while, the market traded below 0.00233695, but eventually continued the upward move, reaching 0.00548800 by May 1, 2017. Here, we see an exit strategy that can be used with moving averages; namely, oscillators. Once we have identified and executed an entry for a trade, we need to figure out an exit strategy. One such strategy is to use the Relative Strength Index (RSI) to identify when the market is overbought or oversold.
With the long positions from 0.00233695, we should look to exit the trade once the oscillator indicator tells us the market is overbought (and hence, due for a reversal). The chart above shows that the RSI breached above 70 on April 27, giving us a sign that we should soon exit.
On April 27, the price stood at 0.00375302 and reached a peak near 0.0055 by May 1. As the price action peaked so did the RSI. Also, we see that the candlestick for May 1 was a Doji, indicating indecision and signals that we should have exited the long on the close of this candlestick at 0.00475853.
Alternatively, we could use the rule of thumb for near consecutive higher highs, which states that we should look to exit a long position once seven to 11 near consecutive higher highs are displayed. Remember, once we have three periods without a new high, the count is over and we start again.
For instance, for the chart below, the count only goes up to ten, because after this high, for the next three weeks no new highs are made, and from the fractal low at 0.00213657, a new high was made every single day or every other day.
Moving Average as Support/Resistance after Golden Cross
After observing the upward trend from the golden cross for ETC-BTC, we expect to see the market find support at the 50-day moving average first and then the 200-day moving average. After observing the market was becoming overextended, we look to buy in again once the market tests the moving average.
The chart below shows how candlesticks can confirm the moving average signals. For instance, on May 9, we see that a perfect hammer candlestick pattern formed, as the wick was roughly three times the length of the red body. The low of the hammer just touched the 50-day moving average, confirming support, and indicating we should look for a long entry here. We also see that during this time, the RSI remains above 50, suggesting momentum is still bullish.
We also get another buy signal on the close of May 17’s candlestick, when the price again once again tests the 50-day moving average. On May 18’s close, we observe a bullish engulfing candlestick pattern and the RSI remains above 50, suggesting it is time to buy.
To exit the long positions, we wait for the RSI to indicate the market is overbought, which occured May 24 as the price broke above 0.0070.
Also, we can use the near consecutive higher high rule, where the peak was achieved on the seventh higher high. Once we see the sixth higher high, we should be ready to sell at points above the high.
Break of Support/Resistance
Later on ETC-BTC experiences a break in the support provided by the 50-day moving average. This is a typical break of support, as we see the market first move below the moving average, then a re-test followed by a continuation of the downward trend. Notice, the momentum oscillator turns bearish after the second break of support. Sometimes, instead of breaking back above the moving average, it will provide more strict resistance, with the upward bounce limited by the moving average line.
Once selling on a break of the support level provided by the slower moving average, we could target the 200-day moving average (or whichever slower moving average you prefer to use). Further along, we see another example of the golden cross, but this time bearish. ETC-BTC then goes onto bottom around November 2017, as the RSI approached the oversold zone.
What about Now?
It’s easy enough to analyse moving averages in the past, after the fact. But here we can show what we have outlined and provide an analysis of the moving averages for ETC-BTC as of the time of writing.
The first close back above the 200-day moving average occured on February 9, giving an buy signal. We also see that the golden cross looks to be imminent, (upward), giving another potential buy. The RSI has formed support above the 50 threshold and moves higher, suggesting momentum is in favor of a buy. Since the fractal low at 0.0023, we have only seen three near consecutive higher highs, so we can expect four to eight more. Remember, if there are three consecutive periods without a fresh high, the count is restarted.
We anticipate a move to 0.0048, as indicated by previous fractal resistance. Alternatively, we can use the RSI and exit the position once the market is overbought. Finally, we can await the golden cross, and wait to observe seven to 11 near consecutive higher highs.
SMAs, EMAs, and Rainbows
Simple moving averages can be coupled with exponential moving averages to give a different perspective. Exponential moving averages, or EMAs for short, place more weight on recent trading sessions. The advantage is that the EMA reacts faster to price changes.
EMAs Give Signals Faster than SMAs
The chart below shows two possible trades using the Golden Cross of the EMAs. At first the faster EMA is above the slower suggesting an uptrend. Once the EMA crossover, with the faster one going below the slower one, we get a sell signal at $16,857.45. We can exit the trade once the RSI approaches the oversold zone, i.e., 30.
Later, a buy signal is given when another crossover occurs when the price is $15,085. The market goes onto to regain $16,875.45, but the RSI indicates overbought conditions around this level, so this would have been your cue to exit.
In short, EMAs are used the same as SMAs but just give a different perspective and faster signals. Remember, moving averages are more reliable on longer-term timeframes and more fake signals will occur on timeframes lower than 4-hour.
The Rainbow indicator: determining trader and investor activity
We can extend the moving average strategy even further by using the Rainbow indicator. The Rainbow indicator provides more detail about the strength of the trend, something not revealed by the simple moving averages. Moreover, the crossover signals are a lagging indicator.
To provide a more detailed picture, the Rainbow indicator separates traders from investors. The short-term indicator represents the actiivty of traders, while the long-tem indicator reveals the actiivty of investors.
To determine the trend, we examine the following:
- Trading activity is displayed the compression and expansion of the short-term group
- Investor activity, degree of expansion or compression in long-term group. A consistent spread, moving in parallel, confirms a strong underlying trend with consistent buying support.
- The degree of separation between the two groups. For instance, the chart below shows trading activity saw a large uptake in early December 2017, with the short-term moving averages started to trend higher. As the price started to move lower, the short-term group started to move closer to the long-term group (red), but never moved below it, suggesting we should look for a bounce and uptrend continuation.
Around December 17, we saw this play out, when LTC-USD tested support around $220 before bouncing and moving back to $280.
Those who own the cryptocurrency need take no action. Those who want to buy may choose to wait another few days for the rebound to develop but there is enough trend strength to make buying on the next day a good trading decision. The stop loss is tight, and placed below the long-term group of averages.
However, the trend was suggested to be weakening once the short-term group started to cluster together and move below the long-term group, as shown below.
The short-term group has penetrated the long term group, but the investors have failed to absorb the traders’ sell off, as the long-term group is now above the short-term group. The red moving averages show that investors will look to sell rallies around $180, unless we see the short-term group converge and start to move back above this level.
So we can use these patterns to identify when the market is finding support and when a reversal is taking place.
Moving averages are a simple strategy you can use to trade bitcoin and other cryptocurrencies. Be sure to use a high timeframe to ensure the signals are reliable, tinker with the settings and backtest your strategy.
Moreover, use the moving average signals in combination with oscillator indicators, candlesticks analysis, and the near consecutive higher high/lower low count to determine targets, as moving averages only provide entry signals and indicate the current trend of the market.
You can read the entire series of BTCManager’s ‘A Guide to Trading Cryptocurrency’ here.