Forex Trading with Moving Averages 

Moving averages are one of the most popular and easy to use tools available to the forex trader. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.

The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

Exponential Moving Average (EMA)

In order to reduce the lag in simple moving averages, technicians often use exponential moving averages (also called exponentially weighted moving averages). EMA's reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA's period, the more weight that will be applied to the most recent price.

Simple Versus Exponential

From afar, it would appear that the difference between an exponential moving average and a simple moving average is minimal. For this example, which uses only 20 trading days, the difference is minimal, but a difference nonetheless. The exponential moving average is consistently closer to the actual price.

By giving more weight to recent prices, the EMA reacts quicker than the SMA and remains closer to the actual price.

The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals.

There are many ways to trade using moving averages and we would like to show one way we like to trade with a moving average set at 200. 

Advanced Trading Method:

Below is a daily forex trading chart with the Commodity Channel Index (CCI) set at 14, Bollinger Bands set at 20 and a 200 Simple Moving Average. We like to use longer time periods as this shows true trend and keeps us out of market whipsaws.

Trading Rules (Going Long):

1. Plot the Commodity Channel Index (CCI) indicator at 14
2. Plot a 200 Simple Moving Average (SMA)
3. Plot the Bollinger Band indicator set at 20.
4. Wait for a the close of price outside the top Bollinger Band line (Point A) and above the 200 SMA and enter.
5. Exit whenever price closes BELOW the top Bollinger Band line.
6. Your stop will be where price touches the lower Bollinger Band line.

Conclusion

Because moving averages follow the trend, they work best when a security is trending and are ineffective when a security moves in a trading range. With this in mind, investors and traders should first identify securities that display some trending characteristics before attempting to analyze with moving averages. This process does not have to be a scientific examination. Usually, a simple visual assessment of the price chart can determine if a security exhibits characteristics of trend.

In its simplest form, a security's price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.

Thank you for joining us in this forex trading lesson.

The Daytradeology Team