Trading Setup Tutorials : "Moving Average Channel Trade Setup"

MOVING AVERAGE CHANNEL

This day trading setup by Jake Bernstein uses a moving average channel to figure out trend and key support and resistance levels. We will build a moving average channel with a 20-period SMA of highs and lows.

Source: The Compleat Day Trader, Second Edition

RULES FOR LONG DAY TRADE

1.  Wait for two consecutive bars to move entirely above the high of the channel.

2.  Buy as price tests the 20 SMA of lows (more aggressive traders can buy on test of 20 SMA of highs).

RULES FOR SHORT DAY TRADE

1.  Wait for two consecutive bars to move entirely below the low of the channel

2.  Short as price tests the 20 SMA of highs (more aggressive traders can sell on test of 20 SMA of lows)

WINNING TRADE – MOVING AVERAGE CHANNEL

This chart shows a 5-minute chart of ES, the E-mini S&P futures. The two circled bars went completely below the moving average channel and confirmed the down trend.

For a conservative trade, we placed a sell limit order at the top of the channel. As prices spiked up to hit the channel top, we entered a short position at 1347.25. Prices continued down until 1338 and gave a profit potential of 9.25 points, while risking almost nothing as the trade went in our direction immediately after we entered.

In this example, the moving average channel highlighted the strong bear spike as price moved beyond the channel. The top channel line gave excellent resistance and minimized our risk. Even if we entered as the bearish outside bar broke the low of the previous bar, it was still a good entry with little adverse movement.

LOSING TRADE – MOVING AVERAGE CHANNEL

Here, similarly, we had two bars entirely below the channel to confirm the down trend. We then shorted with a limit order at around 1356.75. However, the trade went against us almost immediately and forced out any reasonable stop-loss order.

There were warning signs against taking this trade.

First, the two circled bars were not exactly in free fall with the first bar being a doji and the second bar with a long bottom tail.

Next, right after channel break-out, there was a classic double bottom followed by four consecutive bullish bars. Following that, you could notice that each bearish bar was followed by either a doji or a bullish bar, suggesting that the bears were giving up the fight.

Given this bullish context, we should not take a short trade simply because of the rigid trading rules.

REVIEW – MOVING AVERAGE CHANNEL

This trade setup gives the traditional moving average a useful twist. Using the highs and lows to form moving averages is a sound concept as they are the natural support and resistance levels of each bar. Hence, it behaves nicely as support and resistance.

Requiring two bars to go beyond the channel helps to find spikes and avoid ranging conditions.

A potential pitfall of using this trading setup is over-reliance on the moving average channel for support and resistance. This may cause traders to overlook the real price action unfolding before them.

Courtesy - TradingSetupReview