The moving average line can help you see beyond short term market noise and understand the market’s true direction. Here’s how it works.
As any significant time following the forex markets will tell you, movements can be volatile, especially over the short term. Prices will move up and down and will often experience surges before quickly going into a dive creating all sorts of potential for false signals.
A moving average is a way of cutting through the market noise and identifying the key underlying trends.
Moving averages offer a number of indications:
- Indicate trends: When the price is higher than the moving average, the market can be said to be in an uptrend. When it’s below the market is in a down trend.
- Confirm a reversal: The point at which prices break the moving average line in one direction or another can be seen as an indicator of a trend reversal and is often the point at which traders sell or buy.
- Identify areas of support or resistance: Support is when a downward trend may pause due to supporting demand. For example, when the price of an asset falls, demand may rise having a supportive influence on prices. When prices are growing, selling interest can act as a form of resistance on a price. Traders will look at whether prices are moving towards the MA line or away. They will consider it to indicate support if the trend is up and resistance when the trend is down.
There are two common types of moving average. A Simple Moving Average (SMA) plots the average price over a given period of time and is usually a good indication about trends, while the exponential moving average (EMA) gives greater weight to more recent data and reacts more quickly to data.
The EMA is extremely popular in forex and allows traders to make fast trades and to capitalise on an emerging trend earlier.
One of the most common approaches is to take both a shorter term EMA and a longer-term figure and base your decision on where the short term EMA is in relation to the long term EMA. You might sell when the short term EMA crosses below the long term EMA and buy when it crosses from below to above.
Moving average envelopes
Some traders use an MA envelope which uses either a SMA or EMA. It sets prices above and below the MA line to create an envelope. Ideally, traders will only enter into a position when there is a strong overall direction towards a price. On an uptrend, they may buy once the price approaches the middle of the band, this will be considered a long position.
They may consider selling, or shorting, once there is a strong down trend and prices drop towards the middle of the envelope and drop away from it. For safety, traders may exit when the price either reaches the lower or upper range of the envelope band.
Using the moving average ribbon can create a solid basic strategy based on a slow transition change in trend. You can form the ribbon by using a series of 15 EMAs across the whole range of short and long-term averages.
These will all be plotted on the same graphic and will create a ribbon pattern. This can provide an indication of both the direction of the trend and its strength. A steeper angle in which the ribbon fans out can indicate a particularly strong trend.
You will buy when price moves from below the ribbon to the middle and you will sell when it approaches from the opposite direction. In other words, you’ll use the same signals as with other moving average strategies.
Making your move
In a world in which trends can be hard to spot and prices can fluctuate wildly, the moving average is intended to offer a degree of certainty.
It can tell you if a trend is up, down or ranging. It will show if it’s still in motion, reversing or losing momentum. It’s on past prices and lagging indicators, so it tells you nothing about future events but it can provide a signal to confirm a trend is taking place.
This is useful when trying to work out when price volatility is levelling out and a market is setting its true underlying course. As such, it is one of the most useful indicators about when you should buy and when you should sell.
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