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I get this question quite often – why do you use moving averages as dynamic support and resistance? After all, if you’re trading price action why would you need them? They look pretty useless. My answer is always twofold.
In this lesson I’ll cover what moving averages are and how I use them. I’ll also explain why they work and what to watch out for. Like all of the lessons on this site, the effectiveness of this topic is conditional.
That is, moving averages are only as useful as the other confluence factors that are present on any given trade setup. But before we get into the usefulness of moving averages, let’s first understand what it is.
A moving average acts as a smoothing indicator. It does this by representing previous price action for a specific period of time as a smooth line. There are two basic types of moving averages
At this point I could get all technical on the differences, but just know that an exponential moving average places more weight to more recent prices. Because of this, the exponential moving average is considered more reactive, or “up to date” than the simple moving average.
Simple and exponential moving averages act in much the same way. They both represent previous price action for a specific period of time as a smooth line. For instance, a 50 period simple moving average on the daily chart uses the past 50 days of price action to form a smoothed average.
The 50 period simple moving average above is on the daily chart, so it represents the previous 50 days. If this were a one hour chart, the moving average would represent the previous 50 hours.
One last thing about the moving average indicator, is that it’s a lagging indicator. In fact, every indicator is a lagging indicator. The only thing that isn’t lagging is raw price action, which is why I use it. At any rate, moving averages are lagging because they’re based on previous price action. But this is okay because we only use them as an additional confluence factor to our price action trading strategies.
Which Moving Averages Should You Use?
This is another question I get quite often. The answer is subjective and heavily debated. There’s no “right” way to use moving averages. Every trader seems to have their own combination of moving averages that works best for them. I personally use the 10 and 20 exponential moving averages. I have found them to work best with the way I trade price action.
Knowing how to use moving averages and why they’re effective is essential when deciding which (if any) to use. So let’s take a look!
There are two basic ways in which to use moving averages.
Let’s look at how they can help with trends first.
Moving Averages and Trends
Moving averages can certainly help to signal a possible change in trend as well as determine the strength of a current trend. However there are trends in which moving averages will be of little to no help. Take the chart below for example.
The AUDNZD is in such a strong downtrend, that we don’t really need moving averages to tell us this is a strong trend. Now let’s take a look at a chart where moving averages can help to quickly determine the strength of a trend as well as potential changes in trend.
On the chart above, notice how the AUDUSD is trending and not consolidating. This moving average combination is only effective in a trending market. If a market is consolidating or range bound, these moving averages will be of little to no help. Having said that, a trending market is ideal when trading price action.
Now that we understand how they can help with trends, let’s get into how they can act as dynamic support and resistance.
We all know about support and resistance as horizontal lines or diagonal trend lines, but dynamic support and resistance is different.
Before moving on, I want to say that dynamic support and resistance is not nearly as strong or indicative as horizontal and diagonal support and resistance. I don’t advocate ever using moving averages by themselves to define levels of support and resistance. Having said that, they do have their uses.
Dynamic support and resistance can be found where a moving average intersects with the current price. Let’s take another look at the same AUDUSD daily chart. But this time we’ll look for dynamic support and resistance supplied by the 10 and 20 exponential moving averages.
Notice how the 10 and 20 exponential moving averages appear to be providing support and resistance. These two moving averages can be powerful aids, but only used in combination with the right confluence factors. Let’s look at a setup where these moving averages converge with several other factors.
Note: The acronym EMA in the above chart stands for exponential moving average.
Notice how the pin bar (circle) in the chart above rejected the 10 EMA and at the same time rejected a key price action level? We also have an uptrend and no immediate resistance above this key level. This was an “A+” setup. Take note that the 10 EMA was only a fraction of why this was an A+ setup.
The reasons why dynamic support and resistance works are very similar to the reasons why price action works. It has to do with the fact that thousands of traders use moving averages. Of those moving averages that traders use, there’s only a handful of common ones. I would guess that 90% of traders who use moving averages use one of these five periods:
There are other variations out there, but in my experience the majority of traders who use moving averages use one of these. So what happens when 90% of traders who use moving averages use one of these five?
Well nothing, really…
But what happens when 90% of those using moving averages uses one of these AND has come to expect it to act as dynamic support or resistance? I think you know the answer…
Price will generally respect these moving averages in some way, right? It’s self-fulfilling, or rather group-fulfilling. If enough people are watching something, and all expect a general outcome, it’s more likely to happen. This is because many traders (unsuspecting or not) use the moving averages listed above as the “end-all be-all”. They don’t wait for confluence in order to buy or sell.
Like anything else in Forex, there are no guarantees. These moving averages are just another tool we can use. The same goes for price action levels, pin bar and inside bar trading strategies, etc. They are all just individual tools.
I hope this lesson has helped to clarify how moving averages can be helpful even when trading raw price action. My intention was to not only illustrate the usefulness of moving averages as dynamic support and resistance, but to highlight their limitations as well.
Do you use moving averages in your trading? If so, how? If not, did this lesson change your outlook?
Leave your comment or question in the comments section below.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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