In our previous post, you were introduced to the different types of technical indicators – trend, momentum, volume, and volatility. We started trend indicators with a discussion of Moving Average Divergence Convergence (MACD). Now, you should be able to apply it in your trading.
Technical indicators are important. In fact, your knowledge of Forex analysis would not be complete if you do not, at least, understand them. This is because they make amazing tools that you can combine with other Forex principles to identify opportunities to buy and sell in the market.
By applying trend technical indicators, you would be able to gauge market directions. Besides Moving Average Convergence Divergence (MACD), the Moving Average is another trend technical indicator and here is how you can start applying it to your trading right away.
The Moving Averages technical indicator is easily understandable. It is so named because it is calculated by taking the average closing prices of a currency pair over a given number of days. Because it is directly plotted on price charts, this technical indicator is said to be a chart overlay.
You might be wondering: why do I need this indicator since the trend is always easy to see at a glance? Well, you do because in practice, the trend does not always exist as straight lines. Moving Averages will help you smooth out the zig-zags in price to make the trend better seen.
However, this exact benefit of Moving Averages also makes them come with a weakness. The more they smooth out the price, the less responsive to its movements they become. Do not worry, though. The simple solution is to plot your Moving Averages over longer periods.
Types of Moving Averages
There are many types of Moving Averages but the commonest are Simple, Exponential, Smoothed, and Linear Smoothed. The Simple Moving Average is so named because, indeed, it is simple to calculate and use.
Also known as Arithmetical Moving Average, the Simple Moving Average (SMA) is calculated by adding up the prices at which the particular currency pair closes over a number of periods divided by the number of periods. You can use the Simple Moving Average to detect if the price of the pair will continue in its prevailing trend or reverse from it.
The next type of moving average is Exponential Moving Average. Between the SMA and the EMA, which one should you use? The answer is easy. First, the major difference between the two is that while the SMA gives equal emphasis to all values, the EMA, on the other hand, lays more emphasis on recent price data.
As a result, the EMA is more sensitive to most recent changes in price than the SMA. This is exactly why it gives more timely signals and is also preferred to it. In the computation of the Smoothed Moving Average, all the price data are equally used. Also, a longer period is used in the determination of this average. The main use of the Smoothed Moving Average is in helping to actually see prevailing trends while smoothing out short-term price fluctuations.
The Linear Weighted Moving Average is the least commonly used despite placing the highest weight on the most recent price data. As a result, it is more responsive to latest price changes than both the SMA and the EMA. You can, therefore, use it to clearly define price trends, identify potential market reversals, and reveal zones of resistance and support.
How to Use Moving Averages
First, if you would be trading with a Moving Average, it is preferable you use either the Exponential or the Linear Weighted Moving Average. Why? These two, because they focus on most recent data, are the most responsive to price changes. That is, of all, they “lag” the least.
Of these two, the EMA is the more popularly used. In fact, the Linear Weighted Moving Average even hardly comes close in popularity to it. Nevertheless, the two are quite similar in use. For example, the EMA too can be used to identify predominant trends in the market and execute trades using resistance and support.
To be able to do that, it first helps you smooth out price fluctuations. While you would need the SMA as the starting point to calculate the EMA, doing so is not usually necessary at all. Rather, you should just understand how to apply it. This you can do in 6 steps, which are (NB: This is for buy signals. For sell signals, the steps are just in reverse):
Step 1: The first step is to plot on the chart the 20 and 50-period EMAs.
The 20-period and 50-period EMAs. ©️TradingStrategyGuides.
Step 2: Detect automatic signals by waiting for the EMA crossover. This is the point when the 20-period EMA crosses over the 50-period EMA.
The EMA Crossover. The 20-period EMA crosses over the 50-period EMA.
Step 3: Give the market enough time to develop a trend by waiting for the zone between the 20-period EMA and the 50-period one to be successfully and successively retested.
Retesting of the Zone between the 20-period and 50-period EMAs. ©️TradingStrategyGuides
Step 4: Enter a buy trade when the zone is retested the third time. This finally confirms that the trend is up.
Buy at the third retest. ©️TradingStrategyGuides.
Step 5: After the EMA crossover and the third retest and you have entered the buy trade, place your stop loss 20 pips below the 50-period EMA.
Place your stop-loss 20 pips below the 50-period EMA.
Step 6: Set your take profit to when the price breaks and closes below the 50-period EMA.
Set your take profit below the 50-period EMA.
The idea is that when the price is trading above the EMA, the market is in an uptrend and you should expect it to reach for higher prices. So, with such a formation, you can take buy trades. Conversely, when the price is trading below the EMA, the market is in a downtrend and you should be on the lookout for it reaching for lower prices. This can be a good time to sell.
Moving Averages are a highly useful trend technical indicator. By creating a series of averages of subsets in a full set of price data, they analyse different data points of price. Being a trend technical indicator, Moving Averages help you to remove all the noise and precisely lay bare the direction of trend of the market.
Here, we discussed them together with their different types: simple, exponential, smoothed, and weighted. None of these types is best: rather, each is suited for different trading strategies and styles. However, if you do not want to go through the stress of having to choose one yourself, you should rather subscribe for our comprehensive Forex trading signals here.