The use of moving averages in Forex trading is probably one of the most popular methods around. Whether it’s the 20 period, the 50 period, or a combination of different moving averages (9/30 is a popular combination), it’s hard to to see a chart without an average on it.
But does that mean they work? When I say work I mean do they really offer you an edge? What are the most effective moving averages?
In order to determine that, we should first understand how an average is calculated and the first thing we need is price. Since an average needs price to move first, it automatically qualifies as a lagging indicator which I am sure you already knew.
Calculating A Moving Average
Starting with the most basic, a simple moving average, all we have is an average of the X number of days it looks back. It could be calculated from the closing price or an average high, low and closing price depending on the settings you choose.
Keeping it relatively simply: a 10 day sma using closing prices (1+2+3+4+5+6+7+8+9+10)/10 = 5.5
As new inputs come, the first one is dropped and the cycle continues.
If we are looking at an exponential moving average, the calculation is different by taking the more recent data and giving it a higher weight.
Don’t get too caught up in the calculation because it is done for you but knowing how it’s calculated can give you an idea of how they are calculated. The question for you might be “if it’s just a mechanical computation of price points, where is the edge?”
Good question.
Big Players Use Moving Averages In Their Trading
You’ve heard this over and over again: “Hedge funds love the 100 SMA” or something to that effect. How do you know? There has never been a study that I am aware of, and I’ve looked, where someone surveyed all the big players and asked them.
That seems to be one of those “truths” that gets tossed around without any documentation to back it up.
I’ve heard people talk about the “power of the 50 SMA” and how it serves up great trading opportunities. There is a way to use moving averages but thinking it gives any sort of edge by itself is, I think, wrong thinking.
Why 50? Why not 53? Why 20? Why not 32? It’s just an average of price and there is no magic number that is going to make you a profitable trader. The players may use them but they certainly would not use them as the backbone of a trading system.
There are common moving average settings people use but in now way are they the “best moving averages for day trading” or any type of trading.
Use Moving Averages For Pullback Trades
That seems to be a popular example of a trading system using moving averages of all look back periods. Is there an edge? Let’s think about it…..
As price advances and the calculations take place, price will pull away from the average. Fair enough. Price eventually falls and will, at times, come into contact with the moving average. Did the average offer support?
No. Price only met the average because either due to rapid decline and price or a consolidation, the average price of X look back period is getting close to the current price. That’s not to say the mean reversion is not a viable trading edge because it certainly is.
But it’s not the average the causes the edge. At the most, it gives a trader some type of foundation in order to not simply trade at all areas of the chart. It’s what you notice price do at the average that matters.
Look to the left of current price on your chart and see what type of formation or price action has occurred.
One question you read a lot is “what is the best setting for a moving average” and one thing people must understand is that there is no best setting.
Using a short look back period of 10 will obviously have the moving average closer to current price for the most part. Using a 50 period moving average will have the average further away and it cases of extreme movement, very far away. (There is a trading tip in there that I will cover in a moment)
There is no best setting that will make your trading more profitable. Do not waste your time looking for one.
Here Is An Example of Moving Average Method That Makes Sense
Knowing that a moving average is simply a calculation of past price data, how can we use an average like the 50 SMA or 20 EMA in our trading?
The first method is when scanning your Forex charts (any instrument really), you overlay the indicator on that will give you a quick birds eye view of the condition of that market. We don’t need a crossover to tell us of a trend. We can use strategies that are much simpler than that.
Here we have the 50 period simple moving average (sma) on a daily chart of a Forex pair. Seeing that price is cutting above and below the average would tell you that this market is not trending.
That could be great if you are a trader that looks for momentum moves out of consolidations. You would see the shadows rejecting support, especially the long shadow in the middle and this may grab your interest. You may highlight this pair in your watch list, mark off significant areas and set alerts.
So why would this moving average strategy “work”? As we mentioned, it just calculates price and when you get this type of chart look, it tells you that price has not rushed off in any one direction far enough to have the average move away from price.
How About Another Use Of The 50 Simple Moving Average (or, as you guessed, any number)
Markets ebb and flow in impulse moves and corrections. What precedes a correction? A market that has moved some distance in one direction which then sets up mean reversion or a pullback. When we take a pullback trade we are expecting price to make another run but why would it?
The chart above has some nasty price action and there seems to be no rhythm to the way it’s moving. There’s no trend (although on lower time frames there would be) so trading any type of pullback would be a crap shoot.
What about a market that has trended and moved for away from the average price as shown by the moving average? Is it far fetched to expect the move to keep going after a pullback? I am talking best case because you’d want to analyze the swings to ensure we are not looking at a dying last ditch gasp.
This is another example of a moving average method that makes sense.
During your scan you see this market pulling away from the average and up sloping which is a sign of an uptrend (you’d want to use a price pattern method of identifying trend as you drill into the chart). It would make you take pause to investigate further if you are a mean reversion/pullback/reversal trader.
Price has stretched from from the moving average (the stretched elastic band idea) so we know this is a strong market that will pullback in the future. At the red line price pulls back to the 50 period moving average looking like it found support!
It didn’t really find support because of the moving average. Notice the consolidation prior to the pullback which allowed the moving average to start running closer to price. That red line? Markets move in a rhythm and price pulled back virtually identical in distance to a prior swing that start this entire move.
Bonus Trading Tip
Look at the yellow highlighted candles at the top of the chart. Price had stayed in close contact with the moving average after the pullback (because price really did not advance) and those looking for consolidations would take a look at this chart.
A few things you could look at:
- Messy ascending triangle
- Price hugging top of range (sign up upside move)
- Inverse head and shoulders
The price action in the yellow highlighted area is out of the ordinary of prior price action. This has all the hallmarks of exhaustion in this market and you would NOT want to look for a continuation trade after a move like this. It’s even worse on the four hour chart if you had any doubt as to the violence in this move.
An astute trader who paid more attention to price action as opposed to basing everything on a moving average strategy may not have been able to take advantage of this move.
Moving Averages Are Simple Trading Tools
Simple is best and you don’t need to use crossovers or moving average “fans” to get into the market. An understanding of price action trading, swing analysis along with a simple and effective use of a moving average is more than enough.
Of course risk management is paramount but without a means to get into a trade, you won’t have to worry about that.
These two example methods of using a moving average take into consideration the weakness of moving averages (lagging and offer no singular edge) and the mechanics behind market movements. You can certainly design a moving average strategy for your Forex trading signals or any other market by keeping things simple.