Forex traders use moving averages for different reasons. Some use them as their primary analytical tool, while others simply use them as a confidence builder to back up their investment decisions. In this section, we'll present a few different types of strategies - incorporating them into your trading style is up to you!

A crossover is the most basic type of signal and is favored among many traders because it removes the element of emotion from trading. The most basic type of crossover occurs when the price of an asset moves from one side of a moving average and closes on the other. As we've discussed, price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry or exit strategy. As you can see in Figure 1, a cross below a moving average can signal the beginning of a downtrend and would likely be used by traders as a signal to close out any existing long positions. Conversely, a close above a moving average from below may suggest the beginning of a new uptrend.

Figure 1
Source: MetaStock

A second type of crossover occurs when a short-term average crosses through a long-term average. This signal is used by traders to spot when momentum is shifting in one direction and that a strong move is likely approaching. A buy signal is generated when the short-term average crosses above the long-term average, while a sell signal is triggered by a short-term average crossing below a long-term average. As you can see from the chart below, this signal is very objective, which is why it's so popular.

Figure 2
Source: MetaStock

Triple Crossover and the Moving Average Ribbon
Supplementary moving averages may be added to the chart to increase the strength of a signal. Many traders will place the five-, 10-, and 20-day moving averages onto a chart and wait until the five-day average crosses up through the others – this is generally the primary buy sign. Waiting for the10-day average to cross above the 20-day average is often used as confirmation, an approach that can reduce the number of false signals. Increasing the number of moving averages, as seen in the triple crossover method, is one of the best ways to gauge the strength of a trend and the likelihood that the trend will continue.

Some traders argue that if one moving average is useful, then 10 or more must be even better. This leads us to a technique known as the moving average ribbon. As you can see from the chart below, many moving averages are placed onto the same chart and are used to judge the strength of the current trend. When all the moving averages are moving in the same direction, the trend is said to be strong. Reversals are confirmed when the averages cross over and head in the opposite direction.

Figure 3
Source: MetaStock

The shorter the time periods used in the calculations, the more sensitive the average is to slight price changes. Often ribbons start with a 50-day moving average and adds averages in 10-day increments up to the final average of 200. This type of average is good at identifying long-term trends/reversals.

A filter is any technique used in technical analysis to increase one's confidence about a trade. For example, many traders may choose to wait until a pair crosses above a moving average and is at least 10% above the average before placing an order. This is an attempt to make sure the crossover is valid and to reduce the number of false signals. The downside of an over-reliance on filters is that some of the gain is given up and could lead to you "missing the boat". There are no set rules or things to look out for when filtering; it's simply an additional tool that will allow you to invest with confidence.

Moving Average Envelope
One more strategy that incorporates the use of moving averages is known as an envelope. This strategy plots two bands around a moving average, staggered by a specific percentage rate. For example, in the chart below, a 5% envelope is placed around a 25-day moving average. Notice how the move often reverses direction after approaching one of the levels. A price move beyond the band can signal a period of exhaustion, and traders will watch for a reversal toward the center average.

Figure 4
Source: MetaStock

Now that you have a good grip on basic strategies for moving averages, let's kick it up a notch!

Moving Average Flavors

Related Articles
  1. Trading

    How To Use A Moving Average To Buy Stocks

    The Moving Average indicator is one of the most useful tools for trading and analyzing financial markets.
  2. Trading

    Use Moving Averages to Buy Stocks

    A moving average constantly updates a stock's average price, but it cannot predict a stock's performance.
  3. Investing

    Using Moving Averages to Buy ETFs

    Learn how to use moving averages to enter and exit trades in ETFs, and understand some popular technical setups using moving averages.
  4. Trading

    The 7 Pitfalls Of Moving Averages

    While moving averages can be a valuable tool, they are not without risk. Discover the pitalls and how to avoid them.
  5. Trading

    What's a Death Cross?

    A death cross is seen when the short-term moving average of a security or index falls below its long-term moving average.
  6. Trading

    Using Technical Indicators To Develop Trading Strategies

    Unfortunately, there is no perfect investment strategy that will guarantee success, but you can find the indicators and strategies that will work best for your position.
  7. Trading

    A Primer On The MACD

    Learn to trade in the direction of short-term momentum.
  8. Trading

    The Four Most Common Indicators in Trend Trading

    Here are the top indicators and tools trend traders use to establish when trends exist and find entry/exit points.
  9. Trading

    Adjusting Strategies to Moving Average Slopes

    Managing interrelationships between price, moving averages and slope can shift the reward: risk equation in your favor.
  10. Investing

    Double Exponential Moving Averages Explained

    This tweak on moving averages gives traders faster access to the information they need.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center