The Beginners Guide to Technical Analysis Part 3: Moving Averages
Moving averages are a staple in the Forex trader’s arsenal.
They help the discerning trader identify, and trade in alignment with, the trend. Both critical components of a winning trading plan.
There are a variety of ways to use moving averages, the most important of which we will cover today.
What is a moving average?
Moving averages are simply a visual representation of the average price over a number of time periods. For example, the 200-day moving average is the average price of the last 200 days.
Moving averages are plotted alongside the price on the chart:
Simple vs. Exponential Moving Averages
The most common types of moving average are simple (SMA) and exponential (EMA).
A simple moving average is, as described above, an average of the price over a period of time.
An exponential moving average changes this formula slightly by giving extra weight to recent data, making it more responsive to current price movements.
Which is better?
Both work well, and it is simply a matter of testing what is right for you in terms of what you’re trying to achieve at any given point in time.
Leading vs lagging
Moving averages are lagging indicators.
Lagging indicators tell you what has happened in the past, but do not forecast future price moments. This is useful for defining the trend, or identifying support and resistance levels.
In contrast, a leading indicator is designed to predict where the price will move to next. There is a way to turn a moving average into a leading indicator, which we will discuss later in this article.
Defining the trend
One of the most popular ways to use moving averages is to define the longer-term trend.
This is done by plotting a long-term moving average on your chart: 100 or 200 periods are both common, or 50 period for shorter trends.
When the price is trading below the moving average, it confirms we are in a downtrend. When it is trading above the moving average, then it confirms the uptrend.
Moving average cross-overs
One of the most common uses of the moving average is the cross-over.
When a shorter-term moving average crosses over the longer-term moving average it signals a shift in momentum.
For example, suppose a moving average of the price over the last 10 days crosses over the moving average of the last 100 days. Something has happened to the momentum, and it seems to be continuing to happen. Better yet, you have the proof right in front of you.
A cross up indicates the buyers are regaining control, while a cross down indicates the sellers are in the ascendance.
A variation of this approach is to watch for the price to cross over the moving average. You could wait for a price to trade over the moving average, or you could wait for the price to close over the moving average.
These cross overs can be used as entry signals to capture trends.
One mistake traders make is to trade every cross-over of the moving average.
This is a dangerous practice in choppy conditions, as you will get stopped out for a loss time and time again.
Thus, you should only trade a cross-over when you have an expectation that a trend is going to either eventuate or continue.
This could be for fundamental reasons, because you are in a longer-term technical trend, or because you have seen a chart pattern that you think will act as a catalyst.
Some traders will wait for the price to close over the moving average, rather than simply crossing it, in order to avoid false breaks. This is another strategy you can test.
Multiple moving averages
Another method of using moving averages is to combine several progressively faster moving averages on the chart at once.
This could be 200, 100, 50, 25, 10 period moving averages.
When the moving averages are spread out like a fan in the correct order, then it is an indication that the trend is clearly established and you can confidently trade in that direction (for the time being).
When they are not in alignment, or are tightly coiled around each other, then it is an indication that the markets are sideways. You should either stay out, or apply a counter-trend approach to trading these conditions.
Perhaps you have a feeling a breakout is coming, but want to confirm that the market is still technically sideways before you place the trade. Whatever your perception, it is helpful to have the facts in front of you, in an easy to read format such as with moving averages.
Displaced Moving Averages
Displacing a moving average is the practice of shifting it forward in time.
This turns the moving average into a leading indicator, as it is now predicting where the trend will be in future, rather than telling you where it has been in the past.
For example, if the moving average is displaced forward in time by 5 periods, and you believe that the trend is going to hold relatively steady, then you have a visual marker of where the price will be if you’re correct. This can be helpful in timing entries and picking where to take profits.
Moving Averages as support and resistance
Some major moving averages will act as support and resistance levels. The 200 day moving average is an example of moving average that is commonly used like this:
The reason that some moving averages work as support and resistance has to do with market psychology. As the moving average is so closely watched by a large number traders, when the price gets near it, then buying or selling activity kicks in.
This means that if the price falls to the moving average it can cap losses and vice-versa for gains.
Sometimes the simplest approach is the best
Moving averages have stood the test of time.
They are visually simple, easy to apply, and allow for a common-sense approach to the markets.
When you add a moving average into your trading plan, it should have a specific job to do. Understand the type of trend you are looking to capture, and pick the moving average that is best suited helping you trade it.
Don’t overcomplicate things, and you will find moving averages to be one of the most powerful tools in your trading arsenal.
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