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) (blue line) applied to the USD/CAD currency pair. After some mild consolidation in from November through March, the bulls 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 (red 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: Stockcharts.com

Figure 1- USD/CAD: 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: Stockcharts.com

Figure 2 – USD/CAD: 50-day moving average clearly marks levels of support and resistance.

 

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 2, we see this phenomenon in both directions, shown by the red and blue cirlces. The price force of the moves through the moving aveage shown the circles were used by active traders to identify and trade extremely lucrative moves.Chartist can see that once the session breaks below the moving average with speed that the price will likley continue 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 50-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.

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 USD/CAD 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 In early December 2016.

2. While the price moved back above the moving average later in December, active traders were ready to sell the pair again when the price moved back below the support in early 2017. The fast move below the support was an indication that the bears were in control of the momentum and many would have likely made a nice profit trading the move toward 1.30.

3. Using the 50-day moving average as a guide, active traders would set their stop-loss orders above and the 50-day moving average because a move higher would be signal of a move higher. With that said, bullish traders would wait to place a buy order on a move above the 50-day moving average, which occurred in late February as shown by the blue circle. The sharp move above the moving average marked the beginning of a major leg higher. (For more, see: How do I use Moving Average (MA) to create a forex trading strategy?)

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. For more, see: What does “squeezing the shorts” mean?

Textbook Example: Squeeze'um
For a prime example, let's take a look at this snapshot in the currency market in Figure 2. Here, in the USD/CAD, the price forms a formidable resistance level after reversing its role from a key level of support. With such a barrier shown by the red arrow, 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 on the base near 1.30. 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 1.3200 handle, continuing on toward 1.38.

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 3, we will deal with a great example in the GBP/EUR pair. Looking back to March 2016, the pound faced major resistance at the 50-day moving average near $1.1675. After retracing slightly, the buyers win out, pushing the currency pair through the simple moving average and sparking the buying momentum to send the pair almost 300 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: Stockcharts.com

Figure 3: GBP/EUR

 

1. Identify the potential
In Figure 3, the lack in conviction in sending the price lower after a bounce off of the resistance of the 50-day moving average, suggests that the bears are not in full control of the momentum.

2. Zoom into a detailed entry
With the opportunity identified, the trader look for a move above the resistance for an opportunity to enter. The subsequent bounce and move above the moving average (shown by the blue circle) signals the reversal and the bulls all look to enter a position as close to the moving average as possible to maximize their risk/reward.

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 resistance as identified by the 50-day moving average (blue circle). Sometimes an entry higher above the range, such as the open on the day after the breakout, will add an additional confirmation, indicative of the momentum. As a result, the entry will be placed several points above the moving average. The corresponding stop will be placed just below the next level of support, which in this instance is now below the 50-day moving average. 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 few points of risk in this example, as the impending move takes the position higher toward the 1.2000 handle, giving the trader an extremely handsome profit. The result is a risk-reward ratio that is almost 4:1, better than the minimum recommended 2:1 ratio.

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 BehaviorTaking A Chance On Behavioral Finance and Mad Money ... Mad Market?)

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