Moving averages are yet another very common indicator that every forex trader must know how to use because all the major market movers apply this indicators to their trading strategies. So lets dive into this one head first.
What do Moving Averages do?
To put it simply, they give us a much smoother/easier visual representation of what the price action has been doing. So instead of a chart that’s littered with candlesticks that are doing all sorts seemingly random moves up and down, we get a solid line which depicts the AVERAGE price action over the time period in question.
Check out this example:
So how do Moving Averages work?
To calculate a moving average you do the basic math involved with any basic average: take a group of numbers and add them up then divide them by the overall count of those numbers. In other words, for a 5 period moving average you would take the last 5 closing prices, add them up, and divide by 5. For a 10 period moving average you would take the closing price of the last 10 candles, add them up, and divide by… you guessed it 10.
But all this calculating gets done automatically by MT4, or whatever charting program you use, so lets get into how you use them to make money.
How do I trade using Moving Averages ?
Now I am going to have to get technical, so put your thinking caps on for this part and take your time.
There are two types of moving averages with their own advantages and disadvantages.
1) Simple moving averages are the most basic form of a moving average. This means that a simple moving average is a sum of of all candles for however many periods you request divided by the total count of those periods. In other words, SMA’s are less susceptible to fakeouts or huge spikes in price action that usually occur around news events. But also be aware that this also means it is a slow indicator, lagging behind recent price moves which might have signaled an early breakout or end of a trend.
There is another type of moving average that works around this lagging problem:
2) Exponential Moving Averages are more complex because they involve a tweak to the calculation that puts more emphasis on the most recent price action and thus gives you a more up-to-date read on what the price is doing. What this translates to in trading is much less lag and thus quicker identification of early breakouts and trend reversals. On the same note it is important to know that 80% of all breakouts are false signals, so you should never consider this indicator as a stand alone method for identifying such changes in the market. EMA’s give you more of the noise in the market and more noise means more false signals.
So obviously both of these moving average functions have their own pros and cons that cannot be eliminated through some grand philosophical debate. And therefore one must arrive at the conclusion that both MA’s should be used together in some sort of cohesive harmony. The strategy I use to accomplish this harmony is with the Alligator which is in another lesson to avoid having too much material in this one, so check it out next.
One last but very crucial tool that can be applied to your moving averages to give you a great indication of when the price action will correct itself (move back towards the moving average line) are envelopes. Envelopes are also known as standard deviations from the moving average and are representative as such on your chart as parallel lines running along side your moving average. Here’s an example:
Envelopes are similar to Bollinger Bands in that you use them to determine the boundaries of the price action. By boundaries I mean the limits to an upward or downward push at which point the market is very likely going to reverse and go back towards the moving average. Think of envelopes as mini support and resistance lines that tell you how far the price action will stray away from your MA before it returns back towards it. These are great areas to take your profit since they predict very well the limits to which any downward or upward move will stall out and probably move back towards the MA. Conversely, you can also consider them a great way to determine where to place a trade that’s in the opposite direction that the market is moving for some minor pip gains. The essential part in all this is that you set your standard deviation settings so that the bands still catch or contain 90% of the candlestick bodies, otherwise they’re not as reliable at indicating overbought/oversold price action.
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