Limitations of Moving Averages

As an alert reader of articles on BinaryOptionsStrategy.net, you have surely recognized the examples where trading a simple moving average generated almost certain winning trade with a binary option. Before you get too excited, however, please consider that these examples are truly perfect examples. They aren’t hard to find, and there are plenty of other examples just like that. Still, there are just as many examples where trading moving averages or moving average crossovers results in false signals in losses.

The difference between a successful binary options trader and a trader that will lose all its money is that the successful trader knows how to determine the one situation from the other. This article will teach you how to do that.

When not to trade moving averages

Moving averages are great tools to help you make money. Still, they lose their ability to create valid projections in either one of these two circumstances:

1) The market is not in a trend

Often, the market will be in a sideways movement. This can be due to a continuation pattern, a reversal pattern, or a general indecision about what will happen next. During that time the moving average will move sideways, too. As the market is moving erratically up and down, so is the moving average.

If you are trading changes in the moving average’s direction, this period will generate plenty of false signals that can cost you a lot of money. If you are trading moving average crossovers, this period will create many crossovers that all will be false signals, too.

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2) The market is noisy

During some periods, the market follows a strict path along the moving average. Sometimes, however, the market is more volatile, thereby creating many outlying periods that cause the moving average to change direction prematurely and create false signals. These outlying periods are called noise.

A noisy market can render a moving average invalid. While the market remains in its main trend, the noise causes the moving average to create many false signals and cost you a lot of money.

Fixing the problem

When the market is in a sideways movement, there’s little you can do to trade the moving average effectively. Your only chance is to switch time frames and search for trends in a shorter time frame. You should, however, never trade a moving average on a time frame that is in a sideways movement.

Noise, on the other hand, is a problem you can deal with by using more periods to calculate your moving average. When you extent the periods of your moving average from 14 to 28, for example, noise will be much less of a problem. Single outliers periods will simply be less relevant if you extent the basis of your calculation from 14 to 28 periods.

On the other hand, using more days to calculate your moving average will make your moving average slower to react to changes in price direction. It will therefore create fewer signals. If you are looking to reduce noise and thereby to reduce risk, that’s a good things. If you are looking to generate a lot of trading opportunities, however, and can live with the increased risk, extending you moving average probably is not the way you should go.

Also, using more periods can cost you money by generating signals later and causing you to miss out on a potentially big part of the movement. Therefore, finding the perfect number of periods to use with your moving average is a never ending task. During noisy markets, using more periods is the better choice. In a calm market, on the other hand, you should use fewer periods. Since you cannot know which market will happen in advance, this decision depends largely on trial-and-error, your feeling about the market, and what you are most comfortable with.

Still, your goal should always be to use as few periods as possible without getting to many false signals. If you only use very few periods, 3 for example, you will generate many false signals that will cost you a lot of money. On the other hand, if you use too many periods, 200 periods for example, your moving average might not create valid predictions you can trade with short-term investments such as binary options.

More about Moving Averages

If you want to learn more about the use of moving averages in binary options, we recommend you to read the following:

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