Moving Averages in Forex Trading

Moving Averages

10.1. What are Moving Averages?

Moving averages clarify the direction of the underlying trend by smoothing out price fluctuations. This is done by taking the average of the closing prices seen during a fixed period of recent price action. For example, a 50-day simple moving average will sum up the closing prices for the last 50 days and divide this total by 50. The averages are called moving because they calculate a new average with each price bar. For the 50-day simple moving average each day the new close will be added to the total and the close fifty one days back will be subtracted from it. Popular moving averages used in forex trading are 5-day (a week of price data), 20-day (around one month of price data), 50-day, 100-day and 200-day moving averages. The shorter the time period of the moving average the quicker it reacts to changes in trend direction. The longer the moving average the greater it’s smoothing effect, resulting in fewer whipsaws (false signals). Similarly to trendlines the slope of a moving average displays the strength of the current trend. Moving averages are sometimes referred to as automated trendlines.

moving averages

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Apart from the simple moving average described above there can be other types of moving averages. The next most popular moving average used in the currency trading is called exponential moving average. It mainly differs from the simple moving average by giving more weight to the most recent price action - which makes it more responsive to changes in price direction. The following example compares a simple and an exponential moving averages.

simple and exponential moving average

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Note: It is a good practice to use 3 moving averages for each currency pair - one for the short-term (e.g. 5 days), one for the medium-term (e.g. 50 days) and one for the long-term (e.g. 200 days) currency price developments. Use your daily checklist to remind yourself to monitor these averages.

Note: Most major forex newswires and investment banks include moving average analysis in their technical analysis reports.

10.2. Using Moving Averages in Forex Trading

Moving averages give trading signals by interacting with the prices or with each other. If you use one moving average, a signal to buy is generated when the currency prices close above the average; a sell signal is given when the currency prices close below it. A longer-term moving average (e.g. 100-day moving average) will often provide strong support (in up trends) or resistance (in down trends), giving trend continuation signals when the prices bounce away from it

When you use two moving averages with different time periods (e.g. a 5-day and a 21-day moving average), a buy signal occurs when a shorter-term moving average crosses above a longer-term moving average. This crossover signal is also known as a golden cross. A sell signal is produced when a fast moving average falls below a slower moving average. This crossover signal is called a dead cross. The points of old crossovers between the averages will usually act as support or resistance areas in the future. You can also use MACD to anticipate crossovers between two exponential moving averages.

one moving average traging strategy

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two moving averages trading strategy

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Examples of the moving average combinations watched for the dead and the golden crosses are: 5 and 21 days, 5 and 55 days, 21 and 55 days, 5 and 100 days, 5 and 200 days. A dead or golden cross can also involve 3 moving averages (e.g. 5, 22 and 55 days).

Note: Because of they are so simple and objective in defining trends moving averages are very often used in mechanical forex trading systems.

Quote: "One of the great advantages of using moving averages, and one of the reasons they are so popular as trend-following systems, is that they embody some of the oldest maxims of successful trading. They trade in the direction of the trend. They let profits run and cut losses short. The moving average system forces the user to obey those rules by providing specific buy and sell signals based on those principles." John J. Murphy, in his book, "Technical Analysis of the Financial Markets : A Comprehensive Guide to Trading Methods and Applications".

10.3. Mastering Moving Averages

Moving averages are one of the most widely used technical indicators among the professional forex trading community. This makes it important for the currency traders to include moving averages in their analysis (at least the major ones) and to actively watch them. Most books on technical analysis provide comprehensive guidelines on how to apply this technical analysis method.