Most traders and investors still focus on the most traditional forms of investments such as stocks, futures, options and bonds despite the opportunities that the Forex market offers. The Forex market is generally identified as the most liquid and constantly active market in the world. It is only in recent years that individuals are coming to realize the real opportunities that present themselves in the Forex market.
That being said, trading in the Forex market must be carried out very carefully and with a sound strategy in mind. Traders are advised to firstly identify whether they would prefer to use short term strategies or long term strategies. The manner in which they go about trading will be entirely dependent on this decision.
What is a Moving Average?
Traders use moving averages as a technical analysis tool to smooth out price data. Think of it as eliminating the erratic noise to visually represent where a market is moving. The calculation studies many data points to create a series of arithmetic means, each representing a different period.
For example, a market can experience significant swings up or down during a trading month. Although these price swings are accurate, their randomness must represent a clear direction for analyzing price trends. Thus, by using moving averages of this randomness, one can better understand a market’s price trends.
Moving averages are technical indicators that are often used by investors in the stock market. A moving average represents the sum of the closing prices of a security over a set number of periods and is then divided by the total number of periods. Using the 50-day and 200-day moving averages together represent powerful trading signals in the market. Typically, the cross of a stock’s 50-day above its 200-day moving average is a major signal that the stock has begun an uptrend. Conversely, a stock’s 50-day cross below its 200-day MA can signal a downtrend and is often called the death cross.
Trends in the Forex market
While it is true that long term strategies typically have a lower degree of risk associated with them than short term ones, Forex traders still constantly engage in short term trades owing to the fact that they may be more profitable. One of the most common strategies used in Forex trading is that of trading in the direction of the trend. Trading against the trend is extremely risky in comparison. As such, it becomes extremely important to a Forex trader to accurately identify a trend in the Forex market before following it up with a trade. There are a number of ways to calculate these trends. One of the most popular methods used to do this is that of moving averages.
A currency in the Forex market is subject to a number of fluctuations over the course of a time period. These fluctuations are impossible to predict and typically provide little value to a trader. The moving average is used to factor out these fluctuations so that a trader can gain more insight into the direction in which a currency is heading. Objectively identifying a trend is the first step towards setting markers for entry and exit.
Before moving averages can be calculated, it is important to identify a particular time period in which they are to be calculated. The time period that a trader will use will be dependent on what strategy is going to be employed. A major trend in a currency is usually identified as bullish, bearish or neutral. While none of these methods will always hold true, they are tried and tested methods that have proven to be effective more often than not.
A moving average will immediately enable a trader to visualize the major trend that a currency is experiencing, thereby allowing him/her to develop strategies that move along the trend. While moving averages can be an extremely effective technique, it must be said that there is always a likelihood that a currency may display whipsaw signals. Whipsaw signals are generally defined as fluctuations that cannot be predicted or anticipated. These fluctuations make it very difficult for traders to set markers for entry and exit.
How to calculate moving averages
A moving average is generally calculated by splitting a Forex currency chart into individual periods and calculating the average price in each period. These prices are then collated and analyzed to determine what trend a currency is currently experiencing. If these averages seem to be rising, the currency is said to be experiencing an upward major trend. Conversely, if these averages are decreasing, the currency is experiencing a downward trend. In some cases, these averages may display minimal fluctuation thereby exhibiting no real trend. A currency is said to exhibiting a neutral trend in such cases.
Most traders use moving averages associated with different time periods. The shorter the time period in which an average price is calculated, the lesser insight it will provide to a trader. It is this reason that traders generally incorporate three or more moving averages with differing time periods into their strategies. When all three moving averages display an upward or a downward trend, it is generally a good indication that the trend is real and accurate.
While moving averages have continued to be one of the most effective tools in analyzing trends in the Forex market, it is also important to understand that they must be used in conjunction with other indicators. Moreover, moving averages themselves may act as triggers for price action so using caution is always recommended.
3 Ways To Identify A Trend With A Moving Average
The bare basic method of using a moving average to determine the trend is the price crossover.
- When price cuts from below the moving average to above it, it implies a bullish trend.
- When price crosses from above the moving average to below it, it suggests a bearish trend.
This method is simple but useful. Just focus on the slope of the moving average.
- Sloping upwards – Bull trend
- Sloping downwards – Bear trend
The advantage of this method is its responsiveness and simplicity. However, it relies on the moving average alone. Thus, it’s easy to forget about price action itself.
Trading Tip: When the price falls below the SMA, but the slope stays bullish, consider a long setup.
Unlike the first approach, this method forces you to pay attention to price action. It helps you to avoid the common pitfall of relying too much on the indicator.
This method identifies a strong trend. At this stage, the trend is already firmly established.
If you are looking to enter a new trend, this method is not suitable. But if you want to confirm that the most recent trend is a strong trend with momentum, this is the way to do it.
Identifying the trend may reward the trader with higher probability trades. The trend moves in the path of least resistance, allowing the trader to go with the flow of the price action instead of fighting it.
Only one possible trade entry technique was discussed in this article, but there are many more possibilities. Continue studying the markets and finding your optimal entry setups in the context of the trend.
Curious? Try it yourself by trying different moving averages on a price chart, and you’ll get a better sense of how things look from different time-period vantage points. Eventually, you’ll discover which ones might be most compatible with your investing strategy.