The moving average is one of the most used statistical indicators in forecasting price of trading instruments. A moving average is a technical indicator that investors and traders use to determine the trend direction of securities. It is calculated by adding up all the data points during a specific period and dividing the sum by the number of time periods.In this article, we are going to explore moving averages and their effective use in forex trading.
What are the moving averages?
Moving average is the average price of an instrument over a period of time. It is shown as line on a chart. The moving average line results from the average price over a certain number of periods. As a rule, the closing price of a respective candlestick is considered.
Let’s look at the moving average for 20 periods on a five-minute chart: each point of the moving average is determined, based on the average closing price of the last twenty 5-minute candlesticks. As each 5-minute candlestick forms, the moving average continuously shows the average closing price for the previous 20 periods.
Moving averages are not always given for 20 periods. The number of periods can be chosen freely.
For example, the following chart shows a moving average for 200 periods. The calculation is based on the 200 periods preceding the current candlestick.
With moving averages, the price movements are “smoothed” and displayed as a line. This makes it easier for traders to interpret market information, such as the current trend direction.
Different types of moving averages
There are four different types of moving averages:
- Weighted linearly
- Smoothed out
The main difference between these different types of moving averages is how they are calculated. For this reason, they are shown differently on the course chart.
For the simple moving average, each period is weighted equally in the calculation. For exponential, linearly weighted and smoothed moving averages, the focus is on the most recent periods of the count. Look at the 100-period moving average on the chart below in conjunction with the different types of moving averages. As you can see, the moving averages are mapped differently.
- Linear weighted moving average
- Exponential moving average
- Simple moving average
- Smoothed moving average
How to trade forex moving averages?
On the chart below, the direction and strength of the trend can be determined using the slope and angle of the moving average line. If the moving average line is very steep, the price is in a strong trend.
- Flat angle in a range shows a weak bullish trend
- A steep downward angle indicates a strong bearish trend
- A steep upward angle suggests a strong bullish trend
Traders can choose which direction to trade based on whether the price is above or below a moving average.
If the price is above a moving average, it is higher than the most recent average price. So, you can assume that the price may rise. However, if the price is below a moving average, this can be seen as a sign that the price may fall.
Note, however, that this is a subjective assessment. Each moving average refers to the period whose trend you are observing. Other moving averages on the chart should also be considered.
For example, find the information on the chart below. If the price is above a moving average for 20 periods, you could assume that it is currently in an upward trend. At the same time, the price could also be below the moving average for 200 periods. This would put the price in a long-term downward trend overall.
- 20-period moving average indicates a short-term upward trend
- 200-period moving averages, on the other hand, indicate a continuing long-term downward trend
Based on these moving averages, a trader can identify not only the current short-term price trend but also the overarching longer trend.
How can a clear trend be defined using several moving averages?
A trader can use multiple moving averages to identify a clear downward or upward trend.
Because in a clear trend market, moving averages are further away from the price, the more periods they reflect. This can be seen in the chart below:
The price is in a downward trend. The moving average for 20 periods is the closest to the price followed by 50-moving average and so on. The moving averages ordered in this way indicate the downward trend.
- 200-period moving average
- 100-period moving average
- 50-period moving average
- 20-period moving average
Forex Moving Average Strategy
There are numerous variations in moving average trading strategies. However, we discuss multiple facets of moving average strategy that may help you in optimizing your trading.
Selection of Periods
There are no specific rules about the number of periods for which a trader should consider moving averages. The choice is up to each individual.
The shorter the period of the moving average, the faster it changes with the price. At the same time, moving averages for shorter periods offer less reliable information than those for more extended periods. A moving average for a longer period provides more reliable signals but reflects price changes much more slowly.
For example, the 20-period moving average shows the price movement for the last 20 periods, so it shows changes in the price direction very quickly. The downside is that traders often get the wrong signals about trend changes because sometimes short-term price peaks occur.
A 200-period moving average reflects price movements more slowly but also delivers fewer false signals. The disadvantage is that signals are given much less frequently due to the slower imaging.
The following chart shows how the line of the 20-period moving average (black dotted line) changes with the price movement much more frequently than that of the 200-period moving average (red).
- 200-period moving average does not yet reflect the latest price move
- 20-period moving average shows a downward trend
Overlapping moving averages
A trend reversal can be identified by overlapping moving averages. Here, two moving averages are used for different periods to show the short-term and long-term price trend.
If short and long-term moving average lines cross, this may indicate a change in trend direction. Traders can use these crossovers to enter and exit the market at the right time.
The following chart shows a trend reversal from an upward trend to a downward trend. You can recognize this by the fact that the rapidly changing moving average line, which was only below the slowly changing line, crossed it. This shows an apparent reversal of the upward trend in prices.
- Slowly changing moving average
- Fast changing moving average
- Fast changing moving average crosses the slowly changing one
Use moving averages as support and resistance
Moving averages can also be used as indicators of support or resistance and indicate possible market entry or exit points. Specifically, when the price touches the moving average line on the chart, the traders watching the chart place their buy or sell orders. In essence, a moving average works just like horizontal support or resistance line.
If the price is below the moving average, this acts as resistance; if the price is above, the moving average is used as support.
Moving averages are dynamic support and resistance levels as they change with price movements.
- Simple moving average
- Moving average acts as resistance to price movement
Summary of Moving Averages
Hopefully you now of a clear understanding of what moving averages are and how they can be implemented within your forex trading. It could be a good idea to practice trading with moving averages on a demo trading account until you find a way to utilize them that suits your own individual trading style.
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