If you’ve been trading forex for any length of time, you’ve probably heard of the moving average strategy. If you haven’t then fear not. In this article we outline the elements you need to know when it comes to forex trading with moving averages. We’re going to outline exactly what moving averages are, why they matter in trading and more importantly how you can profit from them, even if you are only a newbie trader. Remember to share and comment if you liked the post.
Table of Contents
What are Moving Averages?
Moving averages use a fixed amount of data “X” and relate this against a time period…. Now stay me here. For example you might take a set number of closing prices which would be the “X” figure and then divide these by the number of fixed points of data to give you a basic simple moving average. For example: If you were to plot a 10 point simple moving average on a 10 minute currency chart, you would calculate the total of the last 100 minutes of closing prices and then divide that number by 10. Based on the chart time-scale (10mins / 1 hour / 1 day) depends on how the equation is calculated.
Moving averages are basically a way a trader can gauge the direction a market is heading in, without having to calculate it manually or be put off by short term fluctuations.
Moving Average Basics
As with any forex indicators, moving averages use past price points so have a delay or lag. There are actually 2 types of moving average. The first as discussed above is the simple moving average. These are great for beginners to get an idea of the indicator or signal, but long term knowing the other type and the downfalls of the simple moving average will allow you to avoid any unprofitable trades. The disadvantage to using (solely) simple moving averages is that they are highly susceptible to fluctuations.
Exponential Moving Averages
As previously mentioned simple moving averages can have their downfalls, usually when a spike occurs. For example if there was a piece of news that saw a market spike up or down a short (relative to your trading window) period of time, this would have a huge (and usually irrelevant) effect on the moving average price. To avoid this there is something called an exponential moving average or EMA. An EMA is very similar to the SMA but instead of having all time periods equally weighed, instead this MA gives more “weight” to the most recent data. This is generally seen as better as there is more emphasis on what is happening now, or at least very recently. So let’s have a look at a few charts.
Moving Average Strategies
A crossover is a moving average strategy that involves a price change from one side of the MA to another. Such as that featured in the image right. [image source.] These are usually good signs to enter or close a trade, although other factors should obviously be considered.
Another moving average crossover is one where a long term MA crosses over from a short term MA. This is used to spot when momentum of a pair is changing. For example, usually a buy signal is initiated when the short term moving average moves over the longer term MA. And adversely a sell signal is triggered when the opposite occurs.
A filter is a simple term that is used to improve the confidence of a trading position. Generally traders allow between 5-15% of disparity before opening (or closing) a trade. For example, a trader might wait until the long term MA crosses 5 points above the short term MA.
Moving Average Envelopes
This is a strategy I learnt on investopedia and I’ll quote what they state. Also when you’re finished with this article I’d recommend the moving average flavors article by investopedia. This is the next step to MAs.
One more strategy that incorporates the use of moving averages is known as an envelope. This strategy plots two bands around a moving average, staggered by a specific percentage rate. For example, in the chart below, a 5% envelope is placed around a 25-day moving average. Notice how the move often reverses direction after approaching one of the levels. A price move beyond the band can signal a period of exhaustion, and traders will watch for a reversal toward the center average.
Moving averages are great indicators on whether or not to take out a position. The only issue is they should never be used solely. Personally I use MAs to give me more confidence on a position I’m in or going to take out. If the MA agrees with my position I will more than likely take out a trade, if it disagrees I will continue my analysis or may wait for the market to shift slightly.
Thanks for reading, have a nice day.