Being able to identify trends is one of the most fundamental skills a forex trader should acquire. The main method of identifying trends is by using moving averages. Moving averages are lagging indicators, which means that they do not predict new trends but confirm trends once they have been established. In general, a stock is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Conversely, a trader will use a price below a downward sloping average to confirm a downtrend. Many traders will only consider holding a long position in an asset when the price is trading above a moving average.
The forex market generally tends to moves in trends more than the overall stock market. Why? The stock market is made up of a collection of individual stocks that are generally affected by the micro-dynamics of the particular individual companies. The forex market, on the other hand, is driven by macroeconomic trends that can sometimes take years to play out. These trends usually best manifest themselves through the major pairs such as the EUR/USD, USD/JPY, GBP/USD, and USD/CHF. Here we take a look at these trends and a common moving average technique to detect these trends.
Observing the Significance of the Long Term
Because the forex market is driven dominantly by macroeconomic trends, many traders prefer to base their trades on a long-term outlook. One tool traders frequently use to gauge the strength of a trend is a combination of three simple moving averages called the three-SMA filter. For an example of how they are used, take a look at Figure 1 and Figure 2, which both use a three-SMA filter.
|Figure 1 - Charts the EUR/USD exchange rate from Mar 1 to May 15, 2005. Note recent price action suggests choppiness and a possible start of a downtrend as all three simple moving averages line up under one another.
Figure 2 - Charts the EUR/USD exchange rate from Aug 2002 to Jun 2005. Every bar corresponds to one week rather than one day (as in Figure 1). In this longer-term chart, a completely different view emerges - the uptrend remains intact with every down move doing nothing more than providing the starting point for new highs.
The three-SMA filter is a good way to gauge the strength and direction of a trend. The filter is created by plotting three moving averages on the chart: a short-term, intermediate-term and a long-term moving average. The basic premise of this filter is that if the short-term trend (seven-day SMA), the intermediate-term trend (20-day SMA) and the long-term trend (65-day SMA) are all aligned in one direction, then the trend is strong.
You may be asking yourself why we're using a 65-day moving average here. The truthful answer is that we picked up this idea from John Carter, a futures trader and educator who used these values. But you can use different period moving averages if you wish, the important concept is the interplay between the short, intermediate and long-term averages. As long as you use reasonable proxies for each of these trends, the three-SMA filter will provide valuable analysis. (Another tool used to spot trends is applying envelopes to the moving average. Learn more about this technique in Moving Average Envelopes: Refining A Popular Trading Tool.)
Looking at the EUR/USD from two time perspectives (short and long-term), we can see how different the trend signals can be. Figure 1 displays the daily price action for the months of March, April and May 2005, which shows volatile movement with a clear bearish bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005, and paints a very different picture. According to Figure 2, EUR/USD remains in a clear long-term uptrend despite some sharp corrections along the way.
Warren Buffett, the famous investor who is well known for making long-term trend trades, was heavily criticized for holding onto his massive long EUR/USD position which has suffered some losses along the way. By looking at the long term trend in Figure 2, however, it becomes much clearer why Buffet may have the last laugh. (Want to read more about Buffet? Then check out Warren Buffet's Best Buys.)
Trends will not continue to go in one direction forever. Often times, a trend will reach what is known as a resistance or support, which are price levels that the currency can't seem to push past. We'll introduce you to the concept of resistance and supports in the next section.
Resistance & Support