Another Point of View 2 - the Golden Study 1/4
Due to the variety and complexity of things I will need to talk about, I divided the article in 4 sections.
Whole article will show a study in GOLD, but of course the very same setups are possible in all major currencies, after some correction relatively to the currency behavior.
This first section will be dedicated to understand what kind of MA to apply in a chart, to increase confidence in a trade.
This m30 chart shows one of the most representative situations we find in gold. I drawn some levels based in my approach to a chart as I shown in previous articles (weekly levels, pivots, PA, etc…). I will never be tired to repeat that price is the very 1st thing to look at.
According to the momentum, 1600 was (and is) a demand area while 1700 was (and is) a supply area. I will show in next sections reasons why we have main supply and demand areas and what to do to identify them.
When going from 1600 to 1700, price finds some minor levels, causing reactions in points A-B-C-D. Nobody explain why we should use a SMA instead (for example) of an EMA one, and also why we should use a 30 periods look-back instead (for example) of 200. So I found these differences by myself, deeply studying the tool. I realized something very interesting.
It’s the very same chart with a very completely different study, where I applied some of the most commonly used MA and another one.
Moving averages smooth price data, printing a line that highlights the trend. However, the smoothing process introduces lag. A short-term look-back period MA (blue) respond more quickly to price changes but, due to volatility, can lead to whipsaw losses. Opposite scenario with a long-term look-back period MA (red) due to the heavy numbers of changes it has on it, will not react immediately at market, showing lag in reversal and ranging points.
Quickly analyzing the chart I see as follow:
- A) End of the week, price was below all three MA which usually means a downward move. Green line is also downward. But I repeat: we are at the end of the week and in demand area. Who is so crazy to open a short in GOLD in demand area at the end of the week?!
- B) Price opened week straight bullish going to a minor supply area and then showing weakness. Blue and red lines crossed and reversed down, signaling possible more down, while green line did not at all and still shows upward.
- C) Very similar than previous point: price closing candle below daily opening price and blue + red lines signaling down, while the green one totally not caring and still showing upward.
- D) New situation: price below blue and red lines again, and this time the green one is flat showing a possible weakness.
What happened next?
Same situation with opposite direction. In points E and F blue and red MA signaling upward while the green one not caring at all and still showing (weak) downward and going very near to a good minor supply level.
We must identify which is the very best representative MA for the pair we want to trade. Market changes behavior from a week to another (sometimes in the middle of the week,) and also every pair has different behavior.
In the charts above i applied blue (14EMA) and red (60EMA): they are really no helpful, showing too many ‘false’ signals, while the green MA is very good and always respecting what price is doing and also following very well price when REALLY changes direction but, on the other side, also showing flat in ranging market.
The green MA is the KAMA.
KAUFMAN ADAPTIVE MOVING AVERAGE
The “Adaptive Moving Average” was presented in 1998 by Perry J. Kaufman in his book “Trading Systems and Methods, 3rd Edition”. Kaufman modified the conventional Moving Average with the aid of an “adaptive” approach and the intention to make it more trend-efficient. Simply a genius!
KAMA adapts to market volatility and trend by switching to a shorter-term look-back period when the market is trending up/down, and changing to a longer-term look-back period when the market begins to move sideways.
The (K)AMA builds on the EMA calculation.
The formula is: KAMA = C * (closet – KAMA(t-1)) + KAMA(t.1) where “C” is the adaptive aspect of the smoothing constant and there are a few steps involved in calculating it.
- First step is to calculate the efficiency ratio (ER) (the ratio of price direction to price volatility):
- If price close up 10bars in a row, the ER would be equal to 1, while in ranging market, the ER would be equal to 0.
- Then calculation establish the shortest (fast) and longest (slow) look-back periods that the KAMA will reflect. The SSC (smooth smoothing constant) formula is:
- The EMA smoothing constant calculation, uses the formula 2/(n+1) to approximate the number of bars in a n-bar SMA. Kaufman suggested the (K)AMA range from a 2-bar look-back period (fast) to a 30-bar look-back period (slow).
- Finally, Kaufman noted if market is ranging the (K)AMA would still edge up and down just like an EMA. Squaring the smoothing constant reduces this effect. So:
Applying the KAMA into a chart using JForex platform is very easy, since we already find it in indicators.
As seen in the picture at point (1), I setup to 6 the fast MA periods value; also possible setup to 5. If need something faster/slower, I switch on TF from m30 to m15/h1. At point 3 you could decide to make it recalculate on new candle (better if you do). Point 2 is very subjective.
In this section I shown what is better do to understand which kind of MA use in your trading, according to what you need to read and according to the pair you want to trade.
My trading in GOLD (like every pair) will then require something more than a line in chart, as I will show in next articles. Meanwhile, I hope this will be an easy way for beginners to use a bit more complex tool, but in the same time, something very helpful for trading.
My advice: use ONLY and ALWAYS one MA in your chart.
Good luck in your trading.