3 Ways to Use a Displaced Moving Average (DMA) in Addition to Your Trading Strategy
What is a Displaced Moving Average?
As you have probably noticed, the name “displaced moving average” pretty much contains the answer to this question. The displaced moving average is a regular simple moving average, which is displaced by a certain amount of periods. In other words, displacing a simple moving average means to shift the SMA to the left or to the right. Easy!
How to use the Displaced Moving Average?
Displacing a moving average is a common practice used by traders in order to match the moving average with the trend line in a better way. We all have experienced situations, where the moving average walks the trend line (as a support or resistance), but there are some mismatches and we see that there are slight inaccuracies between the trend and the moving average in the moment of testing the level. Therefore, traders easily “relocate” the moving average forward and backwards by displacing it with a specific amount of periods in order to slide it exactly on the trend line.
It is very important to emphasize that if the moving average is displaced with a negative value, it is displaced backwards (to the left) and it is considered a lagging indicator, while if the moving average is displaced with a positive value, it is displaced forward and it has the functions of a leading indicator. For this reason, the first is used to confirm emerging events on the chart, while the second is more likely to be used for shorter term strategies.
Below you will find an example of the difference between three moving averages.
This is a screenshot of the DAX chart on a H4 time frame. The red line is a standard 50 periods simple moving average. The blue line is a 50 period -5 displaced moving average and the magenta line is a 50 period +5 displaced moving average. As you see, the three lines are moving averages with the same periods. The difference, though, is the displacement factor of the blue and the magenta moving averages. The blue moving average is displaced with -5 periods and it is shifted to the left in comparison to the standard 50 periods moving average (red), while the magenta moving average is displaced with +5 periods and therefore switched to the right in comparison to the red moving average. In this case, the blue displaced moving average (50, -5) looks like a better fit to our trend, because it is a better fit to the already emerged upper trend. Although the price has created a strong bullish movement, an eventual correction would be likely to test the displaced moving average (50, -5) as a support. Yes, it is that simple! A displace moving average is a modification of a standard moving average to better fit a trend line.
How do you recognize which Displaced Moving Average you need?
The answer to this question is quite simple – trial and error! You try; it does not work, so you adjust until it works! Below you see an example, where we have a 20 period Moving Average displaced by +3 periods.
As you see, there are some bottoms here, which conform to the displaced moving average level and use it as a support. On the other hand, there are a few other bottoms, where the price has closed below the displaced moving average. This means, that the moving average might be better to be displaced in the opposite direction in order to give us a better support outlook for situating our stop loss order. Let’s shift the moving average forward! We change our displaced moving average (20, +3) to a displaced moving average (20, -3):
As you see, the bottoms of this uptrend are much better situated on the displaced moving average (20, -3) in comparison to the previous example, where we had few bottoms beyond the scope of the moving average. In some cases, the displaced moving average provides higher level of accuracy for determining support and resistance levels. Therefore, some traders often use this type of moving average in addition to their trading strategy.
How can I adapt the Displaced Moving Average indicator to my strategy?
We are going to go through three suggestions of how the DMAs could be combined with other trading indicators.
- Combining a Simple Moving Average (SMA), with the same period Displaced Moving Average (DMA) + Momentum Indicator
Below you will find a screenshot of the EUR/NZD currency pair on a M30 chart.
We have supported our M30 EUR/NZD Chart by two Moving Averages – SMA 50 (red) and DMA 50, -10 (magenta). In addition to our strategy, you will see below a momentum indicator. The situation on the chart is an example of an opportunity for a short position, which could have led to a profit of about 500 bearish pips in 24 hours. How could we do that? There it is right there!
- First, we start with a strong bearish divergence between the momentum indicator and the previous bullish movement of the EUR/NZD currency pair (marked with the two yellow corridors on the image)
- Second, the momentum indicator interrupts its 100-level line in a bearish direction, which gives us a second bearish signal, speaking of a clear bearish potential.
Not enough? This is where the DMA comes in use.
- Third, the magenta DMA 50, -10 breaks the SMA 50 in bearish divergence, confirming the authenticity of the upcoming bearish activity.
In this case, our displaced moving average formula helped us identify a potential reversal, where the consequences are the following: a strong bearish drop of the EUR/NZD with about 500 pips for 24 hours. The two signals of the momentum indicator inferred about an upcoming bearish activity, while the role of the DMA and the SMA concluded the bearish idea and gave the last bearish signal needed for going short.
At the same time, the momentum indicator is the tool which will give us a proper signal for getting out of the market. If the momentum indicator interrupts its 100-level line in the opposite direction of your position (in our case in a bullish direction), feel free to close your position and to collect whatever you have managed to get out of the trade.
2. Combining a positive and a negative Displaced Moving Average (DMA) with the same period Simple Moving Average (SMA) + parabolic SAR
Below you will see a screenshot of a USD/CAD H4 chart.
Here, we are using three moving averages – two DMAs, 30, -10 (magenta) and 30, +10 (blue), and SMA 30. As you see, we have created a displaced moving average channel, where in the middle we have a control line of a regular SMA 30. The green dots are our Parabolic SAR. So, when do we go into the market?
- First, we wait for a move of the market, followed by a distanced Parabolic SAR point. Look at the chart above and find “I. This Point”. As you see, after the currency pair drops, we get the first clearly distanced dot, which “II. Responds to this candle”.
- Second, after we find our point and respective candle, we check up our DMAs and SMA. We are looking for a distance between them, which will support the bearish movement we are looking for. In “III.” we have the situation we are looking for. The moving averages have just separated from each other, which is our last signal for our short position.
- Third, we go short and we start following the Parabolic SAR indications and the distance between the Moving Averages for an eventual “Get out of there!” signal.
The first more remarkable correction of the bearish drop is noted by 1 Parabolic SAR point – not a big deal. Then we get 9 more bearish points – sweet! Then we get 10, a bigger correction marked with 10 bullish Parabolic SAR points – danger. Nevertheless, we cannot just get out of the market based on a bunch of points. Therefore, we also follow our DMAs and SMA. As you see, in the moment of the dangerous correction, our moving averages recorded a strong hesitation in their bearish intentions, which is the more dangerous event for our position. If you are in the category of the more risky traders and you still want to stay with your position, the day after you will find out that the Moving Averages got closer to each other and even crossed. This should be enough for you to collect whatever you have made out of this short position – between 300 and 350 pips depending on how tough you are!
3. Displaced Moving Average (DMA) and Simple Moving Average (SMA) + Stochastic Oscillator and Relative Strength Index (RSI)
Below you will see an H4 chart of the AUD/USD Forex pair.
In the current example, the DMA (magenta) is modified to fit trend number 3. For each trend should act different DMA, shifted to contain the trend in the best possible way.
In this strategy, we use a displaced moving average (DMA), which should be modified with each swing of the trend, and a bigger period simple moving average, in order to get crossovers of the two moving averages. In addition, we have RSI and stochastic oscillators.
This is how it works:
- First, our initial signal should be from the RSI or the stochastic – to enter the overbought or the oversold market area.
- Second, we get one of these indicators in the overbought or the oversold market area, we wait for the other indicator to do the same and to confirm the signal.
- Third, after we get the second overbought/oversold signal we wait for a cross between the DMA and the SMA. The place of the cross is where we should open our position.
- Fourth, when we open our position, we modify our DMA in order to contain the trend better (shown in 3.)
- Fifth, we close our position whenever the RSI gets into the opposite market area and starts getting out of there, or whenever the two moving averages interact with each other again.
Let’s now go through the particular cases demonstrated in the image above:
Trend 1: We get an oversold signal from the RSI. A second oversold signal comes from the Stochastic Oscillator. Moving averages interact with each other and we go long! Then we modify our DMA to contain the trend better. We follow the trend with our DMA until we see that the RSI goes for a blink in the overbought area and starts moving in the opposite direction. This is where we go out and we collect about 200 bullish pips.
Trend 2: As we said, the RSI gave us an overbought signal. The same happens with the stochastic oscillator. Before we say our names, the DMA and the SMA cross and we go short. We modify the DMA to fit the trend if needed and we start following the sweet bearish tendency. We close our short position in the moment when the RSI goes into the oversold market area. This happens simultaneously with the stochastic oscillator. The result – 130 bearish pips.
Trend 3: The RSI and the stochastic oscillator went in the area of the oversold market. We wait for the DMA and the SMA to interact and to go long. This does not take a lot of time. We go long and we follow our trend with the shifted DMA. Unfortunately, we are forced to get out of the market earlier, because the RSI gets into the overbought area pretty fast. We still manage to realize a decent profit of 160 bullish pips, but we have skipped an opportunity for twice more. That doesn’t matter, because we are pretty happy with our total of approximately 490 pips from three market swings!
It is very important to emphasize that although it does not happen in these three examples, positions should be closed in case of a stronger interruption of the displaced moving average!
Note that each of these strategies could be supported with additional trading tools in order to get clearer signals for going long or short. Therefore, it is always a plus to double check the signal you get with an additional trading instrument, or simple chart patterns and candle patterns. As we all know, there are a lot of them out there!
For example, see in our first strategy by the EUR/NZD, that the last movement of the price ends with a falling wedge formation. We all know its strong bullish potential. Why not take this into consideration?
Look at our second strategy which is demonstrated on the USD/CAD Forex pair. The last few swings of the price draw a pure inverted head and shoulders formation, which support the reversal implied by the Parabolic SAR and the displaced moving average channel. After all, we should not miss the opportunity to be more secure in our trading position!
- The displaced moving average is a great way to adjust a regular simple moving average to fit a trend line in a better way.
- It has the same function as a regular simple moving average – to determine support and resistance.
- If the moving average is displaced with a negative value, it is shifted to the left and it is lagging. If the moving average is displaced with a positive value, it is shifted to the right and it is leading.
- Trial and error is the way to discover the right displaced moving average for you.
- The displaced moving average can be combined with other trading instruments in order to clarify signals from the market. Some of these are:
- Simple Moving Average
- Momentum Indicator
- Parabolic SAR
- Stochastic Oscillator
- Relative Strength Index (RSI)
- Chart Patterns
- Candle Patterns
- Retracement Levels
- Effective trading strategies including the displaced moving average:
- X Period SMA, X Period DMA, Momentum Indicator
- X Period DMA -d, X Period SMA, X Period DMA +d, Parabolic SAR
- X Period SMA, Y Period DMA, RSI, Stochastic Oscillator