Forex Walkthrough

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Charts - Moving Average Explosions

Not only are moving averages used as directional indicators in the forex market, many funds and speculators have used them for other purposes, including key resistance and support levels as well as for spotting turnarounds in the market. These situations offer plenty of profit and trading opportunities for the FX trader, but picking out these situations takes patience. Let's take a look at how a forex trader can use moving averages to profit in the currency markets.

Setting the Stage
In a broader sense, the simple moving average can be compared to the original market sentiment application first intended for the indicator. At first glance, traders use the indicator to compare current closing price to historical or previous closing prices over a specified number of periods. In theory, the comparison should show the directional bias that would accompany other analyses, be it technical or fundamental, in working to place a trade. In Figure 1, we can see the application of the 50-day simple moving average (SMA) (yellow line) applied to the euro/U.S. dollar currency pair. After some mild consolidation in the early part of 2006, bullish buying took over the market and drove prices higher. Here, traders can confirm the directional bias, as the long-term measure is indicative of the large advance higher. The suggestion is even stronger when showing the added 100-day simple moving average (green line). Not only are moving averages in line with the underlying price action higher, current prices (50-day SMA) are moving above longer term prices (100-day SMA), which are indicative of buying momentum. The reverse would be indicative of selling momentum.



Source: FX Trek Intellicharts
Figure 1: Moving averages show the inherent direction



Support and Resistance
Moving averages are not only used in referring to directional bias, they also are used as support and resistance. The moving average acts as a barrier where prices have already been tested. The more tests there are, the more fortified the support figure becomes, increasing the likelihood of a bounce higher. A break below the support would signal sufficient strength for a move lower. As a result, a flatter moving average will show prices that have stabilized and created an underlying support level (Figure 2) for the underlying price. Larger firms and institutional trading systems also place a lot of emphasis on these levels as trigger points where the market is likely to take notice, making the levels prime targets for volatility and a sudden shift in demand. Knowing this, let's take a look at how you can take advantage of this points. (To read more, see Support & Resistance Basics and Support And Resistance Reversals.)



Source: FX Trek Intellicharts
Figure 2: Flatter moving averages are perfect support formations.



Taking Advantage of the Explosion
When institutional investors notice support and resistance levels, these "deeper pockets", along with algorithmic trading systems, will pepper buy or sell orders at this level. These orders tends to force the session higher through the support or resistance barrier because every order exacerbates the directional move. In Figure 3, we see this phenomenon in both directions, most notably to the downside on the daily perspective of the British pound/U.S. dollar currency pair. In both Point A and Point B, the chartist can see that once the session breaks through the figure, the price continues to decline throughout the session until the close, with subsequent momentum taking the price lower in the intermediate term. Here, once through the support line (the 25-day simple moving average), sellers of the currency pair enter and combine with larger orders that are placed below the level. This drives the price farther below the moving average barrier.



Source: FX Trek Intellicharts
Figure 3: Breaks through support or resistance are exacerbated.



Trading this occurrence can be complicated, but it's simple enough to implement. Let's take a look at how to approach this using our British pound/U.S. dollar example:

1. Identify a short-term opportunity on the longer term perspective. Because the longer moving averages are usually the ones getting a lot of the attention, the trade must be placed in the longer term time frame. In this case, the daily perspective is used to identify the opportunity on October 5 (Point B).

2. Zoom into the short term for the entry point. Now we've made the decision for a short sell on the break of the 25-day simple moving average at Point B in the above example, the trader should look at the short term to find an entry point. According to the chart, definitive support is at 1.8850. A close below the support would confirm selling momentum and coincide with the break below the moving average, which represents a perfect short suggestion.

3. Place the entry. As a result of the preceding analysis, the entry order is placed 1 pip below the low of the hourly session, a confirmation of the move lower. Subsequently, the stop order is placed slightly above the broken trendline. With the previous support figure standing at 1.8850, the stop should be set as a trailing stop at a maximum of 10 pips above the current resistance figure. Therefore, the stop is placed at 1.8860, one pip above the session high with an entry in at 1.8812, giving us 48 pips in risk. According to the chart, the trade lasts for almost two days before the price action spikes sharply higher and is ended by the trailing stop. Before that, however, the price action dips as low as 1.8734, providing a potential profit of 78 points, almost a 1.5:1 risk/reward ratio.



Source: FX Trek Intellicharts
Figure 4: Break below SMA coincides with key break below support



A good strategy on its own, the moving average explosion is often associated with the infamous short squeeze in the market. Here, the volatility and quickness in the reactions of market participants will exacerbate the directional price action and sometimes exaggerate the market's move. Although often perceived as risky, the situation can also lead to some very profitable trades. (For related reading, see What does "squeezing the shorts" mean?)

Defining a Short Squeeze
A short squeeze is when participants in the market who are selling an asset must reverse their positions quickly as buying demand over-runs them. The situation usually causes a lot of volatility as buyers pick up the asset quickly while sellers panic and try to exit their positions as fast as they can. The explosive reaction is much more exaggerated in the FX markets. Technological advancements that speed up the transactions in the market as well as stop orders larger traders use to protect and initiate positions result in short squeezes being bigger and more exacerbated in currency pairs. Combining this theory along with our previous examples of moving averages, opportunities abound as trading systems and funds usually place such orders around key moving average levels.

Textbook Example: Squeeze'um
For a prime example, let's take a look at this snapshot in the currency market in Figure 5. Here, in the British pound/Swiss franc synthetic currency pair, the price forms a formidable resistance level. With such a barrier, most of the market is likely to see a short opportunity, making the area of prices slightly above the resistance key for stops that are corresponding with the short sell positions. With enough parties selling, the number of short sellers reaches a low. With the first sign of buying, momentum starts to build as the price begins to climb and it tests the resistance level. Ultimately, after breaking above this level, sellers who are still short begin to consider squaring their positions as they start to incur losses. This, coupled with mounting buying interest, sparks a surge in the price action and creates the jump above the pivotal 2.3800 handle, continuing 50 points higher.



Source: FX Trek Intellicharts
Figure 5: Textbook squeeze takes out short sides.



Combining the Two
Now that we have gone over both the idea of moving average explosions and the mechanics behind the short squeeze, let's see how we can isolate a profitable opportunity. In Figure 6, we will deal with a great example in the European euro / U.S. dollar currency major. Going back to the beginning of 2006, the U.S. dollar strengthened sharply over three sessions. Retracing back to a former support level, buyers and sellers were contending over the previous selling momentum, forming a stabilized support figure. At the start of the range, the body of the candle is as wide as 50-60 points; however, with less momentum and the struggle between buyers and sellers continuing, the session range narrows to 15-20 points. In the end, the buyers win out, pushing the currency pair through the simple moving average and sparking the buying momentum to close almost 200 points above the open price. At the same time, positions that were previously short flip positions to minimize losses, fully supporting the heightened move.



Source: FX Trek Intellicharts
Figure 6: A textbook example comes to life



1. Identify the potential
In Figure 6, the narrow ranges and consolidation in the price action represent a slowing of selling momentum. With the moving average acting as resistance toward the end of the range, an opportunity presents itself.

2. Zoom into a detailed entry
With the opportunity identified, the trader looks at the shorter time frame to make a comprehensive evaluation. In Figure 7, the resistance at 1.1900 is formidable, acting as a topside barrier with the lower support figure around the 1.1800 / 1.1750 figures. Knowing that a short squeeze is an increasing probability, the speculator will take the long side on the trade.

3. Place the entry
Now that the analysis has been completed, initiating the trade is simple. Taking the resistance into account, the trader will place an entry just above the 1.1900 resistance figure or higher. Sometimes an entry higher above the range high will add an additional confirmation, indicative of the momentum. As a result, the entry will be placed two points above the high at 1.1913 (Point C). The corresponding stop will be placed just below the next level of support, in this instance at 1.1849, one point below the 1.1850 figure. Should the price action break down, this will confirm a turnaround and will take the position out of the market.

4. What's the payoff?
The reward is well worth the 64 points of risk in this example, as the impending move takes the position higher above the 1.2100 handle, giving the trader a profit of 187 points before making the move higher to 1.2150. The result is a risk-reward ratio that is almost 3:1, better than the minimum recommended 2:1 ratio.



Source: FX Trek Intellicharts
Figure 7: Trader\'s objective is to capture the explosion.



In Closing
Moving averages can offer a lot more insight into the market than many people believe. Combined with capital flow and a key market sense, the currency trader can maximize profits while keeping indicators to a minimum, retaining a highly sought after edge. Ultimately, succeeding at the moving average explosion is about knowing how participants are reacting in the market and combining this with indicators that can keep knowledgeable short-term traders opportunistic and profitable in the long run. (To read more about market behavior, see Understanding Investor Behavior, Taking A Chance On Behavioral Finance and Mad Money ... Mad Market?)
Moving Average Strategies
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