The most common rule to enter trades based on Moving Average is when Price crosses over the average as seen above. It does have the advantage of getting you on the trade earlier than a Moving Average Crossover strategy but is it the best entry signal based on a Moving Average? Not really
In this post we are going to cover how to use the ZScore Indicator Suite to create a Moving Average Trend Continuation strategy that will give you entry signals at the lowest level possible like the one above without worrying about price possibly continuing in that direction.
In essence, it is a reversal strategy of Price in a lower time frame Moving Average based on a trend stablished by the location of Price in relation to a Moving Average on a higher time frame. Sounds complex but it is not. Let’s get to it!
- Identifying the Lowest Level
In order to identify the lowest level we need to know how deviated Price is from the Moving Average so that we can determine whether a reversal is imminent or whether there is still room for price to keep moving in the same direction.
I highly recommend you read my post on Natural Distribution In it we discussed how 95.44% of the time, price travels between -2 and +2 deviations from the average. 99.72% of the time, price travels between -3 and +3 deviations from price.
Based on the statement above, anytime price is located at <= -2 or >= +2 deviations from the average, there is +95% chances price will reverse.
In the example above we can see how price reversed the moment price reached <= -2 deviations from the average, indicated by a ZScore value of less than -2 from our ZScore Indicator Suite set as Mode:Classic and with a Moving Average period of 200 which is the same period as the Moving Average on the chart. If you are not familiar with ZScore and its calculations, it is recommended that you read over the 5 posts included in the Foundations category.
Trade in the direction of the Trend
You may be wondering, well, I see how price reversed when it hit the lower level but how come it didn’t happen when it hit the upper level? Right! quite the opposite actually, price continue trending upward. You would have been stopped out not only once, but over 5 times! Except one thing….
NEVER, NEVER, NEVER trade against the trend! The Trend is stablished ALWAYS by higher time frames and thus it is MANDATORY to respect the direction at which price is moving.
Those upper breakout are considered entry signals for another type of strategy I will be covering in the future called Moving Average Breakouts, AKA Bollinger Upper Band Breakout, but for now, let’s keep focusing on today’s post…
So far we have 2 rules in place in order to enter trend continuation trades at the lowest level
- Price must be at <= -2 or >= +2 deviations from average at a lower timeframe
- Price must be above the average in the opposite direction at a higher time frame
One of the features of our ZScore Indicator Suite is that it can be applied to any TimeFrame. For example on the image below, we have 1 on the current timeframe giving us the Entry signal and we added a 2nd indicator applied to the Daily TimeFrame and with an Average period of 20, letting us know Price is above the average at higher time frame.
Adding an extra signal confirmation or two!
That along can complete the strategy but I like to add one more filter to this strategy using the ZScore indicator in Mode: ZDEV which calculates the ZScore based on Standard Deviation rather than on Price. It is recommended to set this indicator at a lower period than the Main Average period. Here we have the Main Average at a 200 period and this indicator at 100. Okay, but what does it tell us?
As you see below, as prices were dropping below the average, the 3rd indicator was increasing, a sign that the Standard Deviation itself was increasingly deviated from the average. Crossing below the signal at its peak and continue declining it’s a sign that Price is moving back towards the Moving Average thus giving us an extra signal confirmation of Price reversal for our Moving Average Deviation ~ Trend Continuation Strategy
Last but not least we can add a ZScore indicator in Mode:Volume to give us a confirmation that Volume for Price to continue further down has dried out. Its a bit hard to tell but you can see there was an increased of volume that helped push the price down but soon after it dropped below the zero line, indicating Short traders were done pushing the price down.
I will soon code this strategy into an Expert Advisor that will be available for rent at the MQL Marketplace for the MT5 platform.
I hope you enjoy this article as much as I enjoyed sharing it
FXBABA