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, as discussed in the previous section. 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.

 

The Three-SMA


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 (35-day SMA) and the long-term trend (70-day SMA) are all aligned in one direction, then the trend is strong.

You may be asking yourself why we're using a 70-day moving average here. The truthful answer is that we chose these values because of how the price responded to these levels in the past. As mentioned, 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 USD/CAD 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 February, March and April 2017, which shows volatile movement with a clear bullish bias. Figure 2, however, charts the weekly data from May 2012 to May 2017, and paints a very different picture. According to Figure 2, USD/CAD wavered from its defined uptrend between April 2016 and April 2017 and many active traders were expecting the uptrend to reverse.

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

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