Moving averages (MAs)
As we mentioned in the previous section, some of the most common indicators for tracking trending markets are designed around moving averages.
Moving averages (MAs) smooth out a market’s price movements over a given period so you can see through the noise and spot general trends. They are created by averaging out a market’s closing prices over a given number of sessions.
You can create a moving average for any timeframe you wish. A 20-day MA, for instance, will show you a market’s average price over the past 20 days. A five-day MA, on the other hand, averages out the last five days of price action.
- Types of moving average
- Trading with MAs
- Moving average crossovers
- Trading with MACD
- Moving averages in day trading: example
Types of moving average
There are a few different types of MAs which each calculate averages in different ways. The two most popular, though, are simple moving averages (SMAs) and exponential moving averages (EMAs).
To calculate a market’s SMA, you divide the total of its closing prices over a given number of sessions by the number of sessions. So, if you wanted to calculate a EUR/USD’s five-period SMA, you just take the sum of its closing prices over the last five periods, whether that’s minutes, hours, or weeks, and divide the figure by five.
Calculating EMAs is a little bit more complicated, as they give more weight to price action that is closer to today’s date. Which means that EMAs generally react more quickly than other moving averages.
When you use a moving average on a chart, it will automatically recalculate for each new session. So you’ll see a trend line following your market’s price. The more days you include in the average, the further it will appear from the live price.
The most popular moving averages cover 5, 10, 20, 50, 100 and 200 days.
Trading with MAs
In general, a market may be considered bullish when it is trading above its moving average, and bearish if it is below. However, there are a few other common signals that traders might look out for:
- A buy signal if the moving average is rising and pointing up
- A buy signal if the market closes above the moving average
- A sell signal if the MA is falling and pointing down
- A sell signal if the market closes below its MA
Moving average crossovers
One popular way to MAs is to watch for crossovers. This involves using two MAs at once:
- One is slower, meaning it has a long-term timeframe (say, 50 days or more)
- One is faster, meaning it has a short-term timeframe (15 days or less)
A crossover occurs when the faster MA crosses the long-term one. If it crosses from below to above (crosses up), then it is taken as a sign that the market is entering an uptrend. If it crosses from above to below (down), then a bear run may be on the cards.
The levels at which the lines cross may also become a new support or resistance area.
One drawback to using MAs is that they can be a heavily lagging indicator, as they require lots of past price data to function. Because of this, they may give false signals, when the market move you predicted using the indicator has ended by the time you come to trade it.
As well as being used on their own, moving averages form the basis for several other indicators – including moving average convergence/divergence, or MACD.
When you select MACD on a chart, it will appear in its own box, usually at the bottom. In the box, you’ll see three components:
- The MACD line, which is calculated by subtracting the market’s 26-period EMA from its 12-period EMA
- The signal line, which is a nine-day EMA of the MACD line
- A histogram, which measures the difference between the MACD line and the signal line
If the market’s 12-period EMA is above its 26-period EMA, then the MACD line will be positive. If its 26-period is above the 12-period EMA, then it will be negative.
Trading with MACD
There are three main signals that traders will watch for when using MACD: crossovers, zero-line crosses and divergences.
Just like with standard MAs, a crossover between the MACD line and signal line can indicate that a trend is forming.
If the MACD line crosses above the signal line, it is seen as a bullish signal. If the opposite happens, it is bearish.
Alternatively, you can watch for when the MACD line crosses the zero line.
If the MACD line crosses below the zero line then it may signal a bear run. If it crosses above, it may signal a bull market.
If a market is hitting new highs but the MACD indicator is not following suit, then a divergence may be forming.
This means that the market and indicator are out of sync, and a reversal may be at hand.
Remember, an issue with MAs is that they can lag behind the market’s live price. Additionally, MACD – which is essentially an average of MAs – can lag even more. So, it is particularly important to watch for false signals and pay attention to your risk management when using it.
Moving averages in day trading: example
Even though moving average indicators can lag behind a market’s live price, they can still be used by forex day traders to help understand market conditions prior to opening a position. Let’s take a look at how you could employ moving averages in this way.
Here, 20 and 50-period EMAs are used on a one-hour chart to ascertain a wider trend, with the intention to open and close positions on a 15-minute chart.
Now let’s look at a simple moving average crossover strategy on the chart below. A trader may choose longs when the 9-period EMA crosses above the 21-period EMA, and when price is above the 200-period EMA. Conversely, shorts may be taken when the 9-period EMA crosses below the 21-period EMA, and when price drops below the 200-period EMA.
Here, a long green candle completes above the 200-period EMA and coincides with a bullish EMA crossover, making it a reasonable long-entry choice.
In this case, a tight stop may be placed just beneath the crossover, while a more aggressive choice of stop placement would be further down at the recent swing low. However, a stop that is too tight may exit a trade prematurely, while losses may mount quickly if a stop is too far away. With time, traders can find the balance that works for their style.
You should set the profit target when you look to enter such a trade. Some look for a profit target of 2x risk before they exit, and some will wait till a bearish crossover is generated, although with the latter, the market won’t always make big moves, and a bearish crossover that signals an exit may not present itself when you want it to. Here, a target of 15-20 pips and a stop just below the EMA crossover may provide a risk-reward ratio of around 1:3.
While this example uses moving averages, there is a dizzying range of other day trading approaches available, and a variety of other technical indicators such as MACD, mentioned above, and RSI and Fibonacci retracements, which we will examine in-depth later on. These may each offer specific insight into overbought and oversold levels and key support and resistance areas.
Test your knowledge
- A Buy signal
- B Sell signal
- C Neither
- A Buy signal
- B Sell signal
- C Neither