Every trader in the world knows what moving averages are and their significance. They are so popular than even "big guys" cannot ignore when prices are around an important moving average.
Before looking at multiple ways to use moving averages in Forex trading, let's take some time to talk about what they are. The name is self-explanatory.
A moving average is, above all, a trend indicator. Like most of the indicators that fit into this category, it is applied to the actual chart, on prices.
Trend indicators have one purpose and one purpose only: to show a trend, if any. Therefore, trading with a moving average is strongly related to trading or riding the trend.
A moving average is, like the name suggests, an average of previous prices and the outcome is plotted and compared with the current price. If the result or the moving average is below the current price, the market is in a bullish trend.
The opposite is true as well: if prices are below the moving average, the market is a bearish one. As a rule of thumb, the bigger the period the moving average considers, the more powerful the implications are.
Multiple trading strategies can be used with moving averages and there are different interpretations based on both the time frame the moving average is applied on and the period it considers.
Moving averages are either simple or exponential. The difference between the two comes from the fact that exponential averages are self-adapting to current prices, whereas the simple ones are not.
The first characteristic of a moving average is that is offering support and resistance levels. Having said that, it means that in a bullish trend a long trade can be taken when the price hits the moving average, and in a bearish trend a short trade is recommended when price meets the average.
The chart below doesn't need much explanation. It is the EURUSD pair on the daily time frame, and the black line represents the SMA (50). That is, the simple moving average that considers the previous fifty candles before plotting the current value.
In this case, the average considers the previous fifty days before plotting the current value. As it can be seen, the EURUSD pair was in a bearish market for the last two to three months of 2016, only to break above the moving average in early 2017.
All that time when it was in a bearish environment, short trades could be traded when prices hit the average. By the time there is one candle that closes above the moving average, the trend falters and shorting the pair is not recommended anymore.
A standard market shift is happening when two important moving averages cross. That means that the two moving averages are plotted on the same chart and different time frames.
A golden cross shows bullish market starts and it appears when the SMA(50) crosses above SMA(200). This is a sign everyone in the trading industry considers and it shows market shifting from bearish to bullish.
When the SMA(50) is moving below the SMA(200), it is being said that the market just formed a death cross and it is not wise to stay on the long side anymore. The equities market is influenced heavily by this crosses.
The chart above shows a dead cross on the EURUSD daily chart forming right before the U.S. Presidential elections in the United States. Needless to say, the trend that followed that event was in the direction of the cross.
The bigger the time frame, the more important the cross. In other words, if these crosses are happening on the monthly or weekly charts, the implications are more powerful than when they are forming on lower timeframes like the hourly or four-hour charts.
If a moving average is giving support and resistance levels, multiple moving averages in the same area are giving a confluence area. A confluence area is more difficult to be broken than a level given by one single indicator.
On the EURUSD daily chart above the SMA(20) and SMA(100) were added, in magenta and brown, respectively. Now there are four different moving averages on the chart, and if there's an area where there are two or more averages, that one is a confluence area.
Confluence areas are difficult to be broken and, if anything, they are places where traders are trading more aggressively than normal. The bigger the time frame, the more difficult to break these areas.
To sum up, moving averages are great trend indicators to be used as they leave little room for interpretation. Moreover, they have one big advantage: they are extremely visible and do not repaint.
An indicator that repaints is one that is changing the plotted values in time. This makes it difficult to interpret current prices and to take the proper trading decision.
Dealing with multiple moving averages on a chart is like dealing with a domino effect. No matter the reason why you think the market should turn, it won't turn until the smaller moving average crosses above the next one.
In our example from above, the first bullish sign in a bearish market is when the SMA(20) or the magenta line is crossing above the SMA(50) or the black line. This means the bearish trend falters and traders should look for the market to consolidate for a while until the trend resumes or a new trend in the opposite direction starts.
Moving forward, if the SMA(20) crosses above the SMA(100) as well, chances are a new trend will start. And so on, until all the other averages are turning until we can safely say a bullish environment exists.
Even though moving averages seems to offer a simplistic approach to trading, they work if treated correctly. It is said that in life, simple things work best. The same is valid when dealing with technical analysis and Forex trading.