Moving averages (MAs) are among the most widely used technical indicators by Forex traders, which can make for a very powerful trading strategy. At first glance, it may seem like quite an easy strategy, but there’s a lot more going on underneath. In this post, we’re going to look at which MAs you should use in your trading, why, and how to make the best of them.
The main reason to use MAs in your trading is that they are so common they become a self-fulfilling prophecy. MAs are among the oldest and most commonly used technical indicators (best technical indicators and how to use them), which means that there are thousands of traders looking at the exact same thing. If all these traders react to the same signals provided by the MAs on their Forex charts, then price reacts according to the prevailing market sentiment.
For example, imagine the MAs showed bullish sentiment on a certain pair, preferably one with high liquidity, and all traders opened long positions. The price of the pair would go up just because of the increased demand and keep going as long as the MAs showed continuing bullish sentiment. This characteristic of MAs makes it one of the most powerful technical analysis tools in Forex trading. (Comparing fundamental and technical analysis)
Most useful MAs
There are several ways to look at this issue because, first, there are 2 basic types of MAs, the simple and exponential MAs. Furthermore, both of these MAs can be modified by period, changing the number of trading periods included in the average value.
On the first issue, exponential MAs respond much faster to changing market prices than simple MAs. This is because while the values are being calculated, more emphasis is placed on the most recent data, so any differences between current prices and the most recent data gives a wider variation. As such, exponential MAs are more relevant to short-term traders while long-term traders favour simple MAs.
In the above picture, we have the 100-day MAs, with the EMA in red and the SMA in green. You can see how the EMA is more erratic compared to the SMA. You will also notice how often prices cross the EMA, which would indicate a trend reversal, only for the SMA to hold firm. This is why I recommend the SMA, because it’s more reliable, but I’m sure there are others who will opt for the EMA.
Then there’s the issue of period. I could go into how MAs are calculated, but all you need to know is that it’s an average of closing prices over a given period. The longer the period, the slower the MA is to react and vice versa. You get to enter the exact period you want your MAs to represent, which presents a dilemma. To choose the ideal periods for your MAs, I recommend going for the most commonly used ones.
Since MAs are a self-fulfilling prophecy, you want to be looking at the same thing everyone else is, or at least most other traders. In this regard, I use the 100 and 200-period MAs, which are very common among long-term traders. Both of these are slow MAs, so you will need a fast one, and there’s no consensus here. Personally, I use the 50-period MA because it’s not too fast. As a fast MA, the 50-period SMA has the advantage of being reliable, but it’s slower, which means that I will lose a few pips before the MA responds.
That’s who I am, cautious, but you don’t have to be. An even faster 24-period MA is also common and will identify trends earlier, earning more pips. The danger of fake-outs with this one can be averted as long as you have excellent risk-management principles. To find out what works best for you, try different periods on a demo account first. For the 100 and 200-period MAs, best to keep these ones because most traders will be using them.
Uses of MAs in Forex trading
Once you have your MAs ready, now it’s time to apply them for profit. As I mentioned, they are among the most powerful tools, and that’s because they have different functions:
Swing traders make a lot of money by following long-term trends, accumulating hundreds and even thousands of pips along the way. Anyone can follow a trend, the only trick is to know when the trend has finally ended and then exit your position. Nevertheless, that can be a tricky thing to determine, which is where the MAs come in. To follow a trend with MAs, you will need at least 2 MAs, one slow and another fast.
In the above image, I’ve used 3 MAs on the chart – 200, 100 and 50 simple MAs. Both the 200 and 100 MAs are slow, while the 50 moving average is a bit faster. I could have gone for an even faster MA, but in trend trading, you want the indicators to be slow so that you don’t get any fake-outs.
Looking at the image, you can already see how the price of the GBP/USD pair trends above the MAs all through the uptrend. This is how you use MAs to follow trends. Characteristics of a trend as defined by MAs include:
- Price stay above the slow MAs – at point A in the chart above, price broke through the 200-period SMA to the upside, and stayed that way. Subsequently, the uptrend has never stopped since then
- The fast MAs stay above the slow MAs – after the 50-period SMA crossed above the 100 and 200-period SMAs to the upside, it remained that way for the rest of the trend. As long as the fast MAs are above the slow MAs, it shows that short-term trends correspond to long-term ones, and there is no need to exit the position
When using MAs to ride long-term trends in the market, the key is patience. Very often, the market prices will show a possible reversal in the trend, crossing below the fast MAs frequently, but you need to stay patient and not rush away from any trades. This can also be confirmed through a secondary technical indicator, like the RSI or stochastic oscillator.
At the points marked with a green vertical line, the stochastic indicator helped to confirm the uptrend was still active by showing oversold conditions. By using the MAs and another indicator, you can keep riding a trend for a very long time without having to prematurely closing the position.
The Forex calendar is also useful for confirming trends, since critical news announcements can reverse a trend.
Another profitable trading strategy is through entering trades right when breakouts are forming around support and resistance levels. Furthermore, breakouts can lead to trends which we have already seen how one can ride.
For weeks, the EUR/USD pair has been trading within a range between the points A and B above, when the breakout finally happened. After point B, the pair started an uptrend that kept going for months afterwards. So, how could MAs have shown us the breakout?
- The cross – at point B, the 50-period SMA crossed the 100-period SMA to the upside. Prior to this, it had been stuck below the 100-period SMA, and it was a signal of changing tides. Since the faster MAs react to the most recent market moves, the cross indicates shifting market sentiment. (Forex market sentiment indicators)
- Price closing above the MAs – while trading within the range, prices did not close above the slowest MAs, showing that there was still bearish market sentiment, albeit weak. The breakout could have been confirmed when prices finally broke through the 200-period SMA and closed above it
To enter a trade at the breakout point, ensure that the prices are trending above (on an uptrend) or below (in a downtrend) all the MAs. Often times the prices may break above or below the MAs, but you should wait until the slowest MAs are crossed before entering the trade. Remember that this is a long-term trading strategy, so losing a few pips before the trend was established is worth the confirmation.
However, if you would still like to take as many pips as possible, you can just wait for the cross to occur, which is usually a very strong signal. Besides, as mentioned before, MAs are very powerful because they become a self-fulfilling prophecy when many traders react to the same signals.
Establishing support and resistance levels
In case you’re having trouble establishing and drawing pivot points on your Forex trading platforms, you can use MAs to determine where they are.
The image above represents 100 and 200-period MAs and pivot points drawn along the areas where the MAs change direction. Just by looking at the MAs, it is possible to identify support and resistance levels so that you can know where to enter and exit your trades. (Learn more on pivot points strategy)