How to Use Moving Averages in Forex Trading

by Vahid | Forex Basics | Sunday, May 25th, 2008

Forex (and also stock) traders always look for something that tells them when to buy and when to sell. Although all professional forex traders have their own trading system (strategy) but they love to find easier ways for trading. Easier ways means losing less and gaining more. Making less mistakes and having more successful trades. And moving averages (MA) are the tools that some traders use to eliminate the noises and find good and profitable price movements (trends).

Before I tell you if it is good to trade using the moving averages or not, I have to explain about them and the way they work.

You know how to take the average of a series of numbers. For example the average of 1, 5, 8, 16, 68, 78, 12 and 14 is 25.25. To calculate the average, first you have to add up all the numbers and then divide the result to 8 because we have 8 numbers here. So 202 / 8 = 25.25

Now lets say we want to do the same thing for a currency pair price. This is what a moving average does for you. For example you want to trade the EUR-USD through the 5 minutes chart. The 5 minutes chart is plotted according to the close price in every 5 minutes period. It means each close price in each 5 minute period makes a point and these points create the chart.

Then you add a 20 moving average (20MA) to your chart. This moving average takes the average of each 20 close price. It means each average makes a point and by connecting each point the moving average will form.

Why do we use the moving average?

We use it just because it smoothes out the price fluctuation. It means it eliminates the noises and makes the chart clearer for trading. Let see some examples and then I will explain the different kinds of moving averages and the way you can use them in your trades.

In the below chart, the thick line is a moving average which is set to 20 (20MA) and the thin line is the price. As you see the moving average has eliminated a lot of noise and has smoothed the price fluctuation. You can set your moving average in the way that it becomes plotted with different colors when it goes up or down.

simple moving averages

Let’s try the 40 moving average and see the difference:

So it eliminates more noise if you use a higher setting for the moving average.

Different Kinds of Moving Averages

There are several different methods for the calculation of the moving averages:

1- Simple: All the moving averages explained above are simple moving averages (SMA). As you saw in the simple moving average, just the average of the price will be calculated.

2- Exponential: It has a complicated formula and knowing it will not be any of help for your trading. The only thing you should know is that traders use the exponential moving average (EMA) just because it is faster than the simple moving average. Exponential moving average has less lag (delay) just because they have put more weight on the recent prices than the older prices.

This is true that the exponential moving average is faster than the simple moving average but faster means more noise:

exponential moving average

3- Weighted: It is another kind of exponential moving average but this one also has more weight on the recent prices to make the moving average faster. It has more noise than the simple and exponential moving averages:

Weighted moving average

4- Wilder’s Smoothing: It has less noise than all other kinds of the above moving averages.

Wilder's Smoothing Moving Average

There are some other kinds of moving averages like triangular, end point and time series but I don’t talk about them because they have a lot of noise and have no application in the forex trading. Remember that eliminating the noise was the most important purpose of using the moving averages. So why should we use a moving average that has even more noise?!

How to Trade Using the Moving Averages

It is not recommended to trade only according to the moving averages movements and without using any other indicator. As you could see in the above images, moving averages can shows the trends but when the market is in a consolidation/correction (ranging) situation, they have problems and create a lot of false signals and before you understand that the market is ranging, you may makes some bad trades.

Using several moving averages on the same chart is a good idea to know if the market is ranging or not. Maybe those who created the Alligator indicator had the same thought. Alligator consists of three different moving averages.

Look at the below chart carefully. There are three Wilder’s Smoothing Moving Averages in it:

1- The dark green moving average is set to 9 (Slow)
2- The light green moving average is set to 6 (Middle)
3- The red moving average is set to 4 (Fast)

Also please note that these moving averages are applied to (H+L)/2 and not the close price only. This helps to have a better and smoother moving averages.

These three moving averages make an indicator with each other. This indicator is known as Alligator. It is a good indicator to find the trends and avoid the ranging market.

When Forex market is Bullish (the price is going up) the red moving average (the faster one) stays above the other two; the light green moving average stays at the middle and the dark green moving average (the slowest one) stays under the other two:

Alligator

So when the red MA goes above the others it is time to take a long position and when the dark green MA goes above the others and the red MA goes under, it is time to close the long position or take a short position. As you can see in the above image, there are two “Warning” signals that the red MA tried to cross the other two MAs and it succeeded to cross the light green but failed to cross the dark green. Any of these two “Warning” signals could cause some of the traders to close their long position but those who are more patient and also are familiar with the Elliot Waves, kept their long position and maximized their profits.

Of course the double top could also be known as an early exit point before the Alligator shows the exit signal.

As you see in the Exit Point, the red MA is under the other MAs and the dark green MA is at the top.

This was a beautiful uptrend. But what about the time that the market is ranging?

When we have a flat market (ranging), the three MAs cross each other and also the price for so many times. Sometimes the red is at the top, sometimes the light green and sometimes the dark green. And if you look at the price candlesticks you will see that they are choppy and don’t show a good and clear pattern.

If you have problem in distinguishing the flat/ranging market, adding a Heikin-Ashi chart can be a big help. I suggest you to read my Heikin-Ashi article here. The good thing about Heikin-Ashi is that when the market is Bullish or Bearish and we have good trends, the Heikin-Ashi candles have the same color and shapes. When the market is Bullish, all the Heikin-Ashi candles are green and have no lower shadow and when the market is Bearish, the Heikin-Ashi candles are red and have no upper shadow.

But what about the flat and ranging market? In the flat and ranging market red and green Heikin-Ashi candles will be mixed with each other. Also they will have upper and lower shadows mainly at the same time.

Please look at the below image carefully to understand the above explanations:

Let me show you some more examples:

So when the Alligator and Heikin-Ashi candles tell you that the market is ranging, you have to stay away and wait for a trend.

So is it good to trade using moving averages or not?

It is good but the problem is that moving averages are lagging and delayed. To use the moving averages properly, you have to know a lot more about the market and the behavior of the buyers and sellers. Knowing the Elliot Waves is a big help to avoid taking wrong positions. So moving averages can not be the only thing that you should know and use in your trades. As you saw, I suggested using the Heikin-Ashi candles. I will have to write an article about the Elliot Waves.

Mathematical tools like moving averages and different indicators are good but you have to keep in your mind that forex or stock trading and the prediction of the market direction is mainly based on the psychology of the buyers and sellers and psychology is something that can not be calculated through the mathematics formulas. You have to know the market behavior and this is not possible unless you practice and watch the market movement for a long time.

Ok! I think I have explained enough about the moving averages and the way you can use them to trade. Please let me know if you need more explanations and examples. You can add your comments using the below form. Thanks!

Further Reading:

22 Comments:
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Comment by Milka

2008-05-25 22:18:51

Hi Vahid,
I hope you are feeling well, and just to tell you how glad ‘m I that you are back again!!! This MA lesson is great, like all others you taught us.
Milka