Trading with Moving Averages

By DailyFx | July 26, 2012 AAA

One of the first indicators that traders will often learn is the moving average. Moving averages are simple to calculate, easy to understand, and can provide quite a few different utilities to the trader.

In this article, we'll talk about the more popular uses of this versatile indicator, some of the more commonly looked at moving average inputs, and how traders most often apply them.

The Basics of the Moving Average

At its root, a moving average is simply the last X period's price divided by the number of periods. This gives us the 'average' price over the last x periods. And this will be expressed on the chart, much like price itself.

Trading_with_Moving_Averages_body_Picture_6.png, Trading with Moving Averages
Created with Marketscope/Trading Station II

Looking at price movements expressed as an average can present quite a few clear benefits; primary of which is that the wide variations from candlestick to candlestick are modulated by looking at the average price of the last X periods.

Traders often have the question of whether or not price is too high, or too low - but by simply looking at the average price for this candlestick (in consideration of the prices over the last X periods), the trader gets the benefit of automatically seeing the bigger picture.

Many traders will take the indicator's usage much further; hypothesizing that when price intersects with a moving average, some thing or the other might happen. Or perhaps traders will imagine that if two moving averages crossover, some special event may take place. We'll discuss this below, but for now - just know that the most basic usage of a moving average is to modulate price; attempting to eradicate questions that may pop up from the erratic price swings that can take place from candle to candle.

Commonly Used Moving Averages

There are quite a few different flavors and flairs of moving averages. Some came about out of trader necessity; others came about from traders simply trying to 'build a better wheel.'

The most basic moving average is the Simple Moving Average, which we explained the calculation of above. Traders will use quite a few different input periods for moving average for a number of different reasons.

The most common moving average is the 200 period MA, and many traders like to apply this to the daily chart. It is of the belief that most trading institutions; banks, hedge funds, Forex dealers, etc. watch this indicator. Whether it is true or not can, unfortunately, not be substantiated as most of these institutions keep their trading systems and practices proprietary.

But one look at this indicator on any of the major currency pairings can seemingly prove its worth. The chart below will highlight some of the interesting price action that can take place with the 200 period moving average applied to a daily chart:

Many traders also like to watch the 50 period's moving average. This is thought to be a faster moving average since fewer input periods are used, and the primary effect is that this moving average will be more responsive to more near term price movements. The picture below will show how the 50 periods moving average stacks up to the 200:

Trading_with_Moving_Averages_body_Picture_5.png, Trading with Moving Averages
Price interactions with the 200 period MA; Created with Marketscope/Trading Station

Other commonly used input periods are 10, 20, and 100 settings.

Some traderscommonly use numbers from the Fibonacci sequence as moving average inputs, as shown in my scalping strategy in the article Short Term Momentum Scalping in the Forex Market.

Exponential Moving Averages

Out of trader necessity to more closely follow near term price movements, as many traders feel recent price changes to be more relevant than older price variations, the Exponential Moving Average will place higher importance on price values registered more recently.

Since more recent prices are weighed more heavily than older price swings, the indicator becomes more adaptive to the current price environment. In the picture below, we'll compare the 200 period moving averages as Simple and Exponential MA's.

Trading_with_Moving_Averages_body_Picture_4.png, Trading with Moving Averages
A comparison of Simple (in red) and Exponential (in green) 200 period moving averages

Identifying Trends with Moving Averages

Since moving averages provide the luxury of showing us price in consideration of the last X periods, we have the luxury of being able to observe tendencies which we may be able to take advantage of.

Nowhere is this more prevalent than when using this indicator to define trends, which is often the most common application of the moving average.

If price action is consistently residing above its moving average, with the moving average inevitably pulling higher to reflect these increasing prices - traders can consider the chart to be showing an uptrend.

Trading_with_Moving_Averages_body_Picture_3.png, Trading with Moving Averages
And the exact opposite is true for downtrends.

Trading_with_Moving_Averages_body_Picture_2.png, Trading with Moving Averages
Moving Averages as Support and Resistance

As we were able to see in the above picture of the 200 period moving average, peculiar events can take place when price interacts with one of these lines. As such, many traders will look to moving average intersections as opportunities to buy up-trends cheaply, or to sell down-trends when price is thought to be expensive. The thought being that while an uptrend takes a break by moving lower, down to its average, traders can jump in while price is relatively low. The picture below illustrates further:

Moving Average Crossovers

Some traders will take the utility of the moving average a step further, hypothesizing that when two of these lines cross, something may happen. The 'Golden Crossover,' often referred to in the financial press is simply the 50 periods moving average crossing the 200 period MA. When this happens, some believe that price will continue moving in the direction of the crossover.

Trading_with_Moving_Averages_body_Picture_1.png, Trading with Moving Averages
The Golden Crossover; Created with Marketscope/Trading Station II

Some traders feel moving average crossovers can be ineffective as they can often produce considerable lag to a traders' analysis, compelling traders to buy after an uptrend is well entrenched, or to sell when a downtrend may be nearing its end.

--- Written by James B. Stanley

To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.

To be added to James' distribution list, please send an email with the subject line "Notification," to Instructor@DailyFX.com.

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