September 07, 2017
Moving averages are often used to identify and confirm a trend in the currency market. As described in earlier articles, a trend is simply a price that continues to move in one of three possible directions: up, down or sideways. Now, let’s see how moving averages can be used to find a trend.
The following is a daily chart of EUR/USD with a 100-day moving average (MA) plotted on it.
A moving average confirms a trend if the price crosses below or above the MA, and the MA changes its slope. The first part of the chart shows a downtrend on the EUR/USD pair. At point (1), price crossed the MA from above and changed its slope downwards, signalling that bears took contol over bulls.
The downtrend remained intact until the price crossed the MA from below at point (2). However, an uptrend is still not confirmed as the MA hasn’t changed its slope yet. What we see at the middle part of the chart is a sideways market where the MA remains more or less horizontal.
Finally, at point (3) the price crossed the MA again from below, with the MA changing its slope upwards. The price remains clearly above the 100-day MA, signalling that a possible uptrend has begun.
It’s important to remember that moving averages are lagging indicators, which means that it takes some time until MAs finally confirm that a trend reversal has happened.
How to Use Moving Average Crossovers to Enter Trades
One of the most simple forex strategies, and one of the most popular uses of moving averages, are moving average crossovers. Traders often use a short-term and long-term MA crossover to open trades on the market. There are many MA crossover strategies available on the internet, but we will explain one of the most effective.
For this strategy, plot a 5-period EMA and a 50-period EMA on a 15-minute chart. To enter a long position, wait for the 5-period EMA to cross the 50-period EMA from below, and for the following candlestick to close above the 5-period EMA. To enter a short position, wait for the 5-period EMA to cross the 50-period EMA from above, and for the following candlestick to close below the 5-period EMA.
The following example shows long and short setups based on MA crossovers, on a 15-minute EUR/USD chart.
At point (1), the 5-period EMA crossed above the 50-period EMA and the following candlestick closed above the 5-period EMA. This signals a possible entry into a long position. The same happened again at point (3).
On the other hand, points (2) and (4) show examples of the 5-period EMA crossing below the 50-period EMA, with the succeeding candlesticks closing below the 5-period EMA. These MA crossovers signal an opportunity to enter short positions. Stop-loss levels should be placed very close to the entry point, and moved to break-even as the trade turns profitable. You can also use trailing stops with this strategy.
How to Use Moving Averages as Dynamic Support and Resistance Levels
Moving averages can also be used as dynamic support and resistance lines. They are called dynamic, because these support and resistance lines constantly change in relation to recent price action. They are not like traditional horizontal support and resistance lines which we introduced in earlier articles.
The most popular MA periods that are considered as dynamic support and resistance lines are the 50-period EMA, 100-period EMA and the 200-period EMA. Let’s take a look how a moving average can act as dynamic support and resistance on the following chart.
The green circles show how the 50-day EMA acts as a dynamic support and resistance on the GBP/USD daily chart. As many trader follow the mentioned periods (50, 100 and 200) MAs, their ability to act as support and resistance becomes a self-fulfilled expectation.
Summary: Using Moving Averages
In this article, you’ve learned how to use moving averages in a variety of situations. Moving averages are a very popular technical tool used by traders worldwide. You can use moving averages to find the trend, enter trades on MA crossovers, or simply use them as dynamic support and resistance lines.
The slope of the MA can give a reliable indication of the state of the current trade. Are we in an uptrend, downtrend or ranging market? Looking at the MAs can give us the answer.
MA crossovers, another popular utilization of MAs, can create many trading signals in a short period of time. However, being a lagging indicator, traders should be aware that MAs can also create many fake signals.
Last but not least, many traders watch for the dynamic support and resistance levels created by the 100-day and 200-day EMA, which often act as major turning points for the price.