LESSON-08

Moving Averages.

Forex traders have been using moving averages for decades now and they are still one of the best ways to identify changes in trends. They can even be used for reversion strategies, by taking the opposite direction when a crossover occurs. 

However, moving averages have one inherent flaw which is that they will always be lagging indicators. In other words, by using past data they will only identify a trend once it has already occurred. The problem is speeding up a moving average leads to overshooting the market and more whipsaws. Designing a moving average then, is a trade off between lag and curve smoothness. And what some traders may not know is that there are several types of moving averages out there that aim to solve this issue.

Moving averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands, MACD and the McClellan Oscillator. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). These moving averages can be used to identify the direction of the trend or define potential support and resistance levels.

The Basics of the Moving Average

At its root, a moving average is simply the last X period’s price divided by the number of periods. This gives us the ‘average’ price over the last x periods. And this will be expressed on the chart, much like price itself.

Looking at price movements expressed as an average can present quite a few clear benefits; primary of which is that the wide variations from candlestick to candlestick are modulated by looking at the average price of the last X periods.

Traders often have the question of whether or not price is too high, or too low – but by simply looking at the average price for this candlestick (in consideration of the prices over the last X periods), the trader gets the benefit of automatically seeing the bigger picture.

Many traders will take the indicator’s usage much further; hypothesizing that when price intersects with a moving average, some thing or the other might happen. Or perhaps traders will imagine that if two moving averages crossover, some special event may take place. We’ll discuss this below, but for now – just know that the most basic usage of a moving average is to modulate price; attempting to eradicate questions that may pop up from the erratic price swings that can take place from candle to candle.

Commonly Used Moving Averages

There are quite a few different flavors and flairs of moving averages. Some came about out of trader necessity; others came about from traders simply trying to ‘build a better wheel.’

The most basic moving average is the Simple Moving Average, which we explained the calculation of above. Traders will use quite a few different input periods for moving average for a number of different reasons.

The most common moving average is the 200 period MA, and many traders like to apply this to the daily chart. It is of the belief that most trading institutions; banks, hedge funds, Forex dealers, etc. watch this indicator. Whether it is true or not can, unfortunately, not be substantiated as most of these institutions keep their trading systems and practices proprietary.

But one look at this indicator on any of the major currency pairings can seemingly prove its worth. The chart below will highlight some of the interesting price action that can take place with the 200 period moving average applied to a daily chart:

Many traders also like to watch the 50 period’s moving average. This is thought to be a faster moving average since fewer input periods are used, and the primary effect is that this moving average will be more responsive to more near term price movements. The picture below will show how the 50 periods moving average stacks up to the 200:

Other commonly used input periods are 10, 20, and 100 settings.

Exponential Moving Averages

Out of trader necessity to more closely follow near term price movements, as many traders feel recent price changes to be more relevant than older price variations, the Exponential Moving Average will place higher importance on price values registered more recently.

Since more recent prices are weighed more heavily than older price swings, the indicator becomes more adaptive to the current price environment. In the picture below, we’ll compare the 200 period moving averages as Simple and Exponential MA’s.

A comparison of Simple (in red) and Exponential (in green) 200 period moving averages

Identifying Trends with Moving Averages

Since moving averages provide the luxury of showing us price in consideration of the last X periods, we have the luxury of being able to observe tendencies which we may be able to take advantage of.

Nowhere is this more prevalent than when using this indicator to define trends, which is often the most common application of the moving average.

If price action is consistently residing above its moving average, with the moving average inevitably pulling higher to reflect these increasing prices – traders can consider the chart to be showing an uptrend.

And the exact opposite is true for downtrends.

Moving Averages as Support and Resistance

As we were able to see in the above picture of the 200 period moving average, peculiar events can take place when price interacts with one of these lines. As such, many traders will look to moving average intersections as opportunities to buy up-trends cheaply, or to sell down-trends when price is thought to be expensive. The thought being that while an uptrend takes a break by moving lower, down to its average, traders can jump in while price is relatively low. The picture below illustrates further:

Moving Average Crossovers

Some traders will take the utility of the moving average a step further, hypothesizing that when two of these lines cross, something may happen. The ‘Golden Crossover,’ often referred to in the financial press is simply the 50 periods moving average crossing the 200 period MA. When this happens, some believe that price will continue moving in the direction of the crossover.

Some traders feel moving average crossovers can be ineffective as they can often produce considerable lag to a traders’ analysis, compelling traders to buy after an uptrend is well entrenched, or to sell when a downtrend may be nearing its end.

LESSON-07

How to enter to a trade with the use of MACD indicator.

Traders who use the MACD indicator often are critical of the fact that it will signal an entry after the initial move has begun and therefore leave pips behind. As such, many traders wanting to enter a trade sooner dismiss it as a “lagging” indicator.

In the case of the MACD indicator, the most widely used entry signal is when the MACD line crosses over the Signal Line in the direction of the Daily trend. Since these two lines are simply two moving averages (we are talking about moving averages on our next post), by their very nature the crossover will not occur until the move itself is under way. And, since that crossover is the entry signal, this will get you into the trade after the initial move has begun. Some traders prefer this method of entry as it offers more confirmation that the move is more likely to continue in that direction.

For more aggressive traders who are not interested in the additional confirmation and are simply looking for an early entry, they may prefer a less widely used entry signal based on the histogram bars.

As seen on the 1 hour chart of the EURUSD below, as soon as price action begins to move to the downside, the green histogram bars will begin to shorten. As soon as a bar does not close above the previous bar, that means that upside movement by price has subsided for that moment in time. An aggressive trader can use that as a signal to short the pair at that point.

Traders who are a little less aggressive may prefer to wait until a few histogram bars (perhaps 3-5) in a row close continually lower…or continually higher in an uptrend. This will provide greater confirmation than just one histogram bar but generally will be a quicker entry than waiting for the MACD Line to crossover the Signal Line. As can be seen on the chart below, although the bearish move has begun, the crossover entry signal has not yet taken place.

Note how a trader entering based on the histogram bars would have entered the trade ahead of a trader who entered based on a MACD/Signal Line crossover.

Each of the above entries based on MACD is a valid entry. As usual, it is up to each individual trader to decide which one is right for them.

Keep in mind however  entering a trade sooner means entering with less confirmation and that is not always a good thing.