The Moving average is one of the best tools to identify trends in the Forex market. You should always have it under your radar as it could be highly valuable for your trading strategy. You definitely should know how it works and what moving average tells you before placing trades.
This lagging technical indicator is so important that many of the most popular technical studies use it as part of its calculations. It helps you to avoid the noise in the market and to identify essential levels.
Today in Traders Forex Guide we are going to talk about moving averages and how to use it in the Forex market to improve your trading skills.
What are moving averages
A moving average is a lagging technical indicator that is based on past prices and helps traders to identify trends while filtering out the noise from short term fluctuations. It works in any time frame so that you can use it from a 1-minute or tick chart to 1-week or 1-month graphs.
As one of the core indicators for technical analysis, moving average has a variety of versions with each variant is focused on a specific necessity. The two most popular are Simple Moving Average, the SMA, and the Exponential Moving Average, the EMA.
Moving averages can be customizable by the periods you want to build the rate, but it always responds to the same calculations from its given version. The indicator can also be implemented on all types of charts, including candlesticks, bars, and lines, among others.
Shorter moving averages are denominated as the fast MAs because they change direction quicker than the others which longer time periods, called as the slow. For example, a 50-period moving average will move faster and turn faster than a 200-period moving average. Both are useful and provide good information for the trader, but each one has different implications.
Popular moving average periods are 10, 20, 50, 100, and 200. However, every trader can adapt it to his personal touch. So you can trade using 21-, 55- and 200-period moving averages, for example.
Types of moving averages
As mentioned above, two of the most popular variants of moving averages are SMA and EMA, both offer valuable information to traders, but each answers to different conditions.
Simple moving average
SMA is the easiest version of moving average to be built as it is merely the average price over the given period. If you have a 20 SMA on a daily chart, you are going to have the average price of the latest 20 day periods. In the same way, if you have a 100 SMA in a 1-hour chart, you are going to have the average price for the latest 100 hours.
Now, you can select the way you chose the average price for each period. Although traders usually take the closing price, you will be able to set the average to the high, low, or closing prices of each period.
The Simple Moving Average is calculated by summing all the data for a specific time period and then dividing the sum by the number of periods.
Exponential moving averages
EMA, also known as weighted moving average, gives more preponderancy to the most recent data. Traders do like it because it is focused on the most recent market events and it reacts quicker to recent events. To calculate EMA, you should first have the SMA and then the multiplier for weighting the smoothing value, which is the EMA.
How to find trends with moving averages
Forex and moving averages have a love relationship. Both love each other as Forex uses it as one of the best trend indicators, and the moving average performs really well in the foreign exchange market.
That being said, the easiest way to determine a trend is to plot a moving average on the chart. So, when the price action stays above the moving average, it signals that the pair is in an uptrend.
On the other hand, if the price is below the moving average, then it indicates that the pair is in a downtrend.
Easy, right? Well, no. Let’s say that the EUR/USD is in an uptrend, but suddenly it goes below the SMA as a reaction following an economic report. Then, after the dust of the news settles down the pair returns above the moving average. A problem, right?
Using two and three moving averages
Well, the best option to avoid that problem while identifying a trend is to plot a set of moving averages in the chart. Traders usually add two or three moving averages, one for the short term, other for the middle and the last one for the long picture. It could be 10-period, 20-period, and 50-period moving averages.
So, when the faster moving average is broken, you will have the slower one to confirm or deny the signal.
The theory says that moving averages signal a trend when all two or three lines are aligned in order from fastest to lowest for an uptrend, and from lowest to faster in the downtrend.
The golden cross and the death cross
When trading with moving averages, two MAs can be used to generate two powerful crossover signals, called the “golden cross” and the “death cross.” The signal is produced when the faster moving average crosses a slower MA.
Going long with Moving averages – The Golden Cross
When the faster moving average is below the slower MA for a prolonged period of time, and then it crosses above the long moving average, it is considered as a buy signal. For example, when a 50-day moving average crosses above a 200-day moving average. This technical event doesn’t happen often, but it is considered as a key signal, so either it is true that it is showing a trend shift, or the market sentiment make it happens as everybody thinks it will occur, and act accordingly.
Going short with moving averages – The Death Cross
As the opposite of the golden cross, the death cross occurs when a faster moving average broke below the slower MA. So, if the 50-day moving average cross below the 200-day MA, it is considered as a bearish signal.
That being said, remember that as traders, we accumulate hints about what the market will do, but nobody, and I repeat, nobody knows for sure what the market will do. So, the best option is to combine moving averages with other indicators.
How to trade forex with Moving averages
When it comes to trading Forex with moving averages, it is essential to understand that it helps traders to identify trends, and even it provides buy and sell signals. However, moving averages also have limitations, especially when the market is not trending.
Moving average crossovers are popular among traders as a source for entry and exit points, support and resistance levels, and overall it helps to understand market sentiment.
However, remember that moving averages look better when the market is uptrend or downtrend, not when it is sideways. Also, the longer the trend is, the better the quality of the crossover will be.
Finally, use moving averages in combination with other technical indicators and fundamental data. Never go long right before a critical resistance, or short when the price is facing strong support. Also, economic data can shake prices above or below moving averages; in that case, you may want to wait for the dust to settle.