Moving averages are one of the most commonly used trend-following indicators available to forex traders. Almost all traders have used these at some point and they form an integral part for many trading strategies. The value of a moving average is that it can show traders both the current direction of the trend as well as provide very effective support and resistance levels across all currency pairs. Although moving averages are lagging indicators, meaning that they show traders where price is in relation to historical price rather than predicting future movements, their importance is highlighted by their use in key indicators such as Bollinger bands and the MACD.
What is the moving average?
The moving average is a basic line indicator which appears on price charts moving roughly with the peaks and troughs of the price. It is based on a calculation taking in to account a set number of historical data from whichever timeframe it is applied to. For example, the 20 simple moving average takes the closing prices of the past 20 price bars and divides them by 20 to find the mean average. The number of bars included in the calculation will determine how responsive the moving average is to fluctuations in price. Moving averages using a large number of price bars, such as the 200 Moving average, move slower and appear much smoother than the 5 moving average.
Two types of moving average
There are two types of moving average used by forex traders. This is the simple moving average (SMA) as described above, and also the exponential moving average (EMA). The exponential moving average uses the same principle as the simple moving average in calculating data from the past number of price bars, but it applies more weight to the most recent price bars. The theory behind adding additional influence to the most recent price bars is favoured by some forex traders as it gives a more accurate reflection of the current trend. By applying more weight to the most recent data, an exponential moving average will therefore have less lag than a simple moving average and also be more reactive to price fluctuations. On the other hand, the straightforward simple moving average will better identify areas of support and resistance more accurately and forex traders will tend to view the SMA as much more influential in forming these areas. In particular, the 20, 50 100 and 200 simple moving averages are considered the most popular and influential levels on any timeframe.
Trading using the moving average
In trading with both the SMA and the EMA both can be used for classic crossover signals. This is one of the most popular and also straightforward methods of trading forex and involves entering a position when a lower moving average, such as the 20, crosses above or below a slower moving average, such as the 200. These crossovers are known as bullish or bearing crossovers and can be very effective in showing short-term changes in the trend. However, due to the fact that moving averages are lagging indicators of price movement, the entry signals will always be delayed. This means that crossover trading methods may not be best employed alone but often require an additional indicator or signal in order to confirm the trade and to avoid whipsaws in the market.
Moving averages as support and resistance
Moving averages are also very helpful for traders to identify a clear ‘map’ of the market and the most important of these will create potentially significant areas of support and resistance. This significance is heightened when the moving average combines with another support or resistance level such as a round number, pivot point or Fibonacci level. The indicators can therefore assist traders in avoiding problems of trading in to areas of congestion and problems as well as allowing them to prepare for price ‘bounces’ off the moving average, or a change of trend direction as price moves above or below the longer moving averages.
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