Moving averages are one of the more popular technical indicators that traders use in the Forex market. In fact, moving averages are the only indicator I use as part of my trading strategy.
As popular as they are, one question remains at the top of the list for most traders – “how do I use moving averages?”
That’s exactly what you’re about to learn in this lesson. We will cover what moving averages are as well as the various ways to use them. We will also discuss some of the limitations that all traders should consider before adopting moving averages into their trading strategy.
What is a Moving Average?
The first thing to note about the moving average is that it’s a lagging indicator. This means that it’s based on past price action.
There are two basic types of moving averages – the simple moving average (SMA) and the exponential moving average (EMA). As the name implies, the simple moving average is a simple average of a currency pair’s movement over time. The exponential moving average on the other hand gives greater weight to more recent price action.
The moving averages that we will be looking at in this lesson are the 10 and 20 exponential moving averages. I prefer exponential over simple as I feel it gives a better indication of what is happening rather than what has happened.
Ways to Use Moving Averages
There are many ways in which to use moving averages, but the three methods below are my personal favorite.
One thing to keep in mind as we move through the lesson, is that a moving average or moving average combination should never be used alone. Because it is a lagging indicator, the moving average should always be used in combination with other price action patterns and signals to help put the odds in your favor.
Trend Analysis
The use of moving averages for trend analysis is arguably the most common use of the indicator. There are many variations of moving averages that a trader may use to analyze a trend, but my favorite combination is the 10 EMA and 20 EMA.
Like most things in the Forex market, using moving averages to analyze a trend isn’t a perfect science. Nor is it something you want to rely on by itself. However when used properly, these two moving averages can make identifying a trend much easier.
Let’s look at an example.
Notice in the AUDUSD daily chart above how we are only looking for buying opportunities when the 10 EMA is on top of the 20 EMA. Because the 10 EMA follows price action more closely than the 20 EMA, when it’s on top it’s signaling that the market is in an uptrend.
On the flip side, when the 10 EMA is below the 20 EMA, we only want to be looking for selling opportunities as this often represents a downtrend.
Dynamic Support and Resistance
These two moving averages can also be used as dynamic support and resistance. There are several moving averages which carry more weight than others in the market, and the 10 and 20 period moving averages are among them.
Here is a list of the five most common moving averages that Forex traders use:
- 10
- 20
- 50
- 100
- 200
Because the periods above are commonly used, the market tends to respect them more than others. It’s the same reason that support and resistance levels work in the market – if enough traders are using the same level to buy or sell a market, then the market is likely to react accordingly.
Let’s take a look at the 10 and 20 EMA acting as dynamic resistance during a downtrend.
Notice how once the 10 EMA crossed under the 20 EMA, it began to act as dynamic resistance. This type of dynamic resistance combined with a price action sell signal can be a powerful combination.
Identifying Overextended Markets
Last but not least is using moving averages to help determine if a market is overextended. One of the more common pitfalls among Forex traders is buying or selling too late. We want to avoid entering a market that has overextended itself, and moving averages can help us determine if this is the case.
What does it mean to be overextended you ask?
Simply put, all markets normalize after an extended move up or down. This may come in the form of sideways price action or even a retracement. By using the 10 and 20 EMA we can stay away from trying to join the trend too late.
It should be noted that this method goes hand in hand with using moving averages as dynamic support and resistance.
Here’s an example of how to use moving averages to avoid selling an overextended market.
In the NZDJPY daily chart above, the market made two extended moves down, away from the 10 and 20 EMA. As price action traders, we want to avoid entering a market that has made an extended move away from our moving averages.
Instead we want to wait for the market to normalize and come back to the moving averages before looking for a sell signal to join the trend.
Summary
I hope this lesson has given you some ideas about how to use moving averages. Although there are dozens of ways to use them as part of your trading strategy, the three methods detailed above are my personal favorite and have served me well over the years.
Let’s recap some of the more important points from the lesson.
- There are two basic types of moving averages – the simple moving average and the exponential moving average
- The exponential moving average gives greater weight to more recent price action
- Although useful, the moving average is a lagging indicator that should never be used by itself to enter a trade
- Moving averages can be used to quickly identify a trend, making it easier to know whether to look for buying opportunities or selling opportunities
- The 10, 20, 50, 100 and 200 period moving averages are the most common and can therefore be used as dynamic support or resistance
- The 10 and 20 exponential moving averages are great for identifying markets that may be overextended