Moving averages are commonly used in technical analysis to help traders identify the direction of the trend and potential levels of support and resistance. However, using multiple moving average lines can provide even more insight into market conditions. By observing the behavior of these lines with respect to each other, traders can better understand whether a trend is in effect or if the market is consolidating.
Figure 1: Moving Average Action during the Trend and Consolidation Phases.
When a trend is in effect, multiple moving average lines will start to diverge from each other. The greater the divergence, the stronger the trend is likely to be. For example, if we are looking at a daily chart and we see the 10-day, 50-day, and 200-day moving averages all diverging from each other, this indicates that the market is in a strong uptrend. Conversely, if we see these same moving averages all converging towards each other, this suggests that the market is potentially entering a consolidation phase.
During trending phases, moving averages will display a lower incidence of whipsaws. A whipsaw occurs when the market briefly moves against the trend, causing a trader to exit a position prematurely or enter a position in the wrong direction. When the market is trending strongly, moving averages will generally continue to move in the direction of the trend, minimizing the occurrence of whipsaws.
However, during any consolidation phases, moving averages will exhibit a significant increase in whipsaw action. This is due to the flattening-out effect of averages in a sideways or ranging market. When the market is not trending, moving averages will not be as effective at predicting future price movements, and traders may need to rely on other technical indicators or strategies.
In addition to identifying trends and consolidations, multiple moving averages can also help traders determine potential levels of support and resistance. For example, if a short-term moving average crosses above a longer-term moving average, this can indicate that the market is potentially entering a bullish phase, and the shorter-term moving average may act as a level of support. Conversely, if a short-term moving average crosses below a longer-term moving average, this can indicate that the market is potentially entering a bearish phase, and the shorter-term moving average may act as a level of resistance.
Multiple moving averages can be a powerful tool for traders to identify trends and consolidations in the market. By observing the behaviour of these lines with respect to each other, traders can better understand whether the market is trending or consolidating and adjust their strategies accordingly. It is important to note, however, that moving averages should not be relied upon as the sole indicator of market conditions, and traders should use other technical indicators and fundamental analysis to confirm their trading decisions.