Two moving averages can be pretty useful company, but is three a crowd? Who really needs to use three moving averages? Believe it or not, some very successful longer term trading systems make comparisons using three moving averages. The technique is useful because it allows the market to be defined as having no trend, as opposed to either an up or downtrend.
You may be thinking, "No trend? The market and stock prices change daily! There has to be a trend!" But some markets (and individual stocks in particular) have long droughts without an up or downtrend. Identifying a market without a trend can be extremely helpful, as it's pretty difficult to make money trading when there isn't much price movement. With that in mind, taking a look at combining three moving averages is certainly worth the time.
Comparisons using three moving averages are made by identifying each average as either fast, medium, or slow. Just like comparisons with two moving averages, the one considered "fast" has the lowest number of data points. The slow moving average has the most data points, and the medium one is somewhere in the middle. To help you visualize, see Figure 11-8, which contains a 5- and 20-day moving average but also includes an additional 10-day moving average.
In Figure 11-8, the averages are represented by different lines:
^ The 5-day moving average is represented by the solid line. ^ The line with long dashes is the 10-day moving average. ^ The 20-day moving average is the line with the short dashes.
A chart with both a 5-day and 20-day moving average.
A chart showing a 5-, 10-, and 20-day moving average combined.
With any chart containing three moving averages, you can pick out an uptrend when the fast moving average is higher than the medium one, and the medium one is higher than the slow one. You can see an uptrend on the right side of this chart, where all three moving averages are in order and trending together.
You can identify a downtrend when the fast moving average is lower than the medium one, and the medium one is lower than the slow one. If the fast-, medium-, and slow-moving averages aren't lined up either fast to slow or vice versa, you can safely say that the market has no trend.
Knowing the type of market you're dealing with is key to using many candlestick patterns correctly, so you may need to use three moving averages. That's especially true for longer term trading. The more certain you can be about a trend, the more likely you are to properly identify and trade effectively on a bullish or bearish candlestick pattern.
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