From Philipp Pfitzenmaier at Trade with Precision:
When looking for a trading opportunity, we would usually have a checklist to turn to. Item number one on the list would be to choose a chart with “optimal chart structure”. Optimal chart structure is when a chart exhibits a clean, smooth flowing trend which is one of the cornerstones of the trend trader’s arsenal of technical analysis tools. But how can we determine if the chart structure is what we are looking for or not?
The more experienced traders out there would be able to spot an optimal trending chart quite simply by relying on their experience garnered through time spent analysing charts. However, a newbie trader could find these difficult to spot in real-time. That’s where the humble moving average comes into play …
It would be necessary to add at this time that we (TWP) choose to not use moving averages in the traditional sense: we are not looking for crosses of moving averages or for touches or crosses of price with moving averages. These occurrences tend to give signals in hindsight which could ultimately mean that we get the signal after the opportunity has already passed us by: we are late to the party!
Instead moving averages can help us to identify a promising chart structure for our trend following setups by focusing on identifying good moving average geometry. The correct geometry of multiple moving averages can be a good indication of a strong and healthy trend. So what do we mean by “moving average geometry”?
We use four simple or exponential moving averages (as we aren’t trading off them we can choose either option): the 10 & 20 period (or fast moving averages), the 50 period which is a medium moving average and a long term 200 period moving average. We analyse how these four dynamic lines of equilibrium move in relation to each other to paint a picture of what the underlying trend is doing and whether or not the chart has optimal chart structure.
We are looking here for several things: First, we would like to see, that all moving averages are in the correct order for the trend (e.g. for an uptrend: 10 > 20 > 50 > 200). Next we would like to see good separation between them with no hectic crosses due to erratic price action, but slow and steady movement in the direction of our trend.
Let’s consider the daily chart of Banc of California:
With the four moving averages added, you can easily see optimal chart structure and the picture painted by our moving average geometry is one of a clean, smooth flowing trend.
Another example of this moving average geometry can currently be seen on the chart of California Water Service Group:
While the separation of the two fast moving averages in this example is not as pronounced as in the previous example, we can still see a very steady uptrend in action. No hectic and erratic movements but slow and steady price action.
These are the type of charts we are looking for when searching for trading opportunities for our trend following strategies. Does this suggest that we already have an entry signal? No! Optimal chart structure is one factor, an important one yes, but only one technical factor none the less and we want to have as many factors supporting our trading decision as we can. Sign up for the CMC Markets Next Generation Trader to learn more on how you can master finding optimal chart structure using moving averages as well as how to combine multiple technical analysis factors to form a decisive trading strategy.
As always: happy trading!