Moving Averages in Choppy Markets

Mind Without Fear said :

“could you please comment on another aspect of strategies that are based on moving average cross overs? I find that there are inevitable periods of whipsaws that eat away profits. Typically, after a big move, there are a series of false signals generated by the cross over system. What filter can be used to not trade these false signals? I mean I know there will be false signals, I just want to avoid some of them, avoiding all of them is not possible. Will really appreciate your thoughts on this.”

This excellent question really deserves an answer, as early as possible. Avoiding whipsaws while trading moving averages (MA) is a trader’s dream. Why ? MA ensures that all big trends are captured by the trader. But, when the market does not have a trend, the MA casues a lot of trading with almost all of the trades losing money. We continue to trade with MA signals since one of these signals is likely to be the ‘Big One’. Unfortunately, we do not know which one, so we take all signals. This becomes a vicious circle – MA trades are taken since one of them may be the big one – the trades keep on losing money since this is a choppy market – then even more reason to take the trades since the losses will be compensated by the big one – choppy markets continue…. Finally, the trader gives up and says “I do not want to take the next trade” – and the next trade happens to be the big one.

Is there some way that can reduce the number of false trades caused by choppy markets ? Before we discuss this, I must explain that trading is never easy. There are no mathematical formulas to get the right entry and exits. So, the pain really goes with the gain.

Now, for some ideas.

1. Trading Ranges. Many of these ‘false’ signals come inside trading ranges. Now the first one or two signals may come in when the range is under development, so you really do not know that you are in a trading range. Once or rather, IF, you can identify a range, then you can stop taking signals until prices move out of the range. Suppose the latest MA signal was a sell, then you wait patiently for prices to close below support. That is the point when you will take the sell signal. Once you take the signal, you should follow the MA trade .

2. Filters to entry exit signals. When MA signal is received, then buy only above the high of the last 3 bars or sell only below the low of the last thee bars. Many choppy signals will fail to cross this threshold. You can innovate by creating your own ‘buy above’ and ‘sell below’ levels.

3. Multiple contracts. If you can trade in multiple contracts, take profits on some of the positions on a big move (range expansion) in your favor. While this method does not improve the quality of your signals, it does ensure a smoother profit curve.

4. Pyramiding. Start with the lowest possible number of contracts when a new signal comes. As the signal becomes profitable, add more contracts. Therefore, the choppy signals will be stopped out with the smallest volume, while the winners will add profits on more contracts.

5. Higher time frames. if you are trading on 60 minute charts, use a daily chart to determine the trend. Then, on the 60 min, take trades only in the direction of the daily trend.

Think out of the box, and, you will find many innovtive ideas. Then follow a few, consistently.