Moving Averages are common tools most FOREX traders use in analyzing and trading the FOREX markets. They are one of the most powerful tools used by technical traders due to its high degree of accuracy and reliability, probably due to the fact that they don’t re-paint like other indicators available to be used by technical traders. When back-testing a strategy with Moving Averages, you have no need to worry about errors because whatever signal you see on the right side of your charts(past) is what you get using the MA’s in the real life markets(present and future). Unlike other indicators that repaints and it’s not reliable, the Moving Average stands out distinctively. This makes the Moving Average one of the best indicators in the FOREX world. However, a lot of traders don’t realize this, probably because they fail to understand how to apply this remarkable indicator. This article is to show you how to use the Moving Average indicator in its best form which I will be explaining in the next paragraphs.
First of all what is a Moving Average? A Moving Average is an indicator in technical analysis that is used to smoothen out price action by filtering out the “noise” from random price fluctuations. A moving average (MA) is a trend-following or lagging indicator because it is based on past prices. There are 4 major types of moving Average namely the simple moving average, smoothed moving average, Linear weighted moving average and exponential moving average. The two basic and commonly used MAs are the simple moving average (SMA), which is the simple average of a security over a defined number of time periods, and the exponential moving average (EMA), which gives bigger weight to more recent prices. The most common applications of MAs are to identify the trend direction, spot reversals and to determine support and resistance levels. While MAs are useful enough on their own, they also form the basis for other indicators such as the Moving Average Convergence Divergence (MACD) and partially the stochastic oscillator.
There are several ways a Moving Average could be applied to the properties of a candle-stick to predict the future. These properties include the open, high, low and close of a candle-stick. The most reliable property of a candle-stick to apply the moving average to is the closed price of a candle-stick. Another parameter to consider when using the moving average is the time period you want to be smoothened. A 10-day MA would average out the closing prices for the first 10 days as the first data point which would give you a clue where price is heading towards. As noted earlier, MAs lag current price action because they are based on past prices; the longer the time period for the MA, the greater the lag. Thus a 200-day MA will have a much greater degree of lag than a 20-day MA because it contains prices for the past 200 days. The length of the MA to use depends on the trading objectives, with shorter MAs used for short-term trading and longer-term MAs more suited for long-term investors. The 200-day MA is widely followed by investors and traders, with breaks above and below this moving average considered to be important trading signals.
A simple method of how to use the Moving Average is the cross of two moving averages, one usually the smaller time period and the other the longer time period. For example, if 20 EMA crosses 50 EMA upward, this signifies a bullish trend or buying opportunity and if the cross happened to be downward, this signifies a bearish trend or selling opportunity. Some of the primary functions of a moving average are to identify trends and reversals, measure the strength of an asset’s momentum and determine potential areas where a currency pair will find support or resistance. This is picture of an example of a buy and sell signal resulting from crosses of MA’s.
Another common use of moving averages is in determining potential price supports. It does not take much experience in dealing with moving averages to notice that the falling price of a currency pair will often stop and reverse direction at the same level as an important average. Many traders will anticipate a bounce off of major moving averages and will use other technical indicators as confirmation of the expected move. Moving Averages can also be used to determine resistance in a downtrend. Many short sellers will also use these averages as entry points because the price often bounces off the moving average which is acting as a resistance and then continues its move lower. If you are an investor who is holding a long position in a currency pair that is trading below major moving averages, it may be in your best interest to watch these levels closely because they can greatly affect the value of your investment.
The support and resistance characteristics of moving averages make them a great tool for managing risk. The ability of moving averages to identify strategic places to set stop loss orders allows traders to cut off losing positions before they can grow any larger. Using moving averages to set stop-loss orders is key to any successful trading strategy.
MA’s also impart important trading signals on their own when candle-sticks close above or below them. Another useful way to use the MA’s is when a fresh cross of MA’s occur after a high impact fundamentals is been released. For example the picture below shows a sell trading signal from the USD Non-Farm Pay Roll released on April 4, 2014.
Another signal for selling opportunity resulting from ECB Press Conference on May 8, 2014.
In Conclusion, Moving Averages are one of the best tools available for technical trading and if well used can bring promising returns on Investment.