How To Trade Using Moving Average Trading Strategy

WHAT IS A MOVING AVERAGE?

  • It is a very popular  forex indicator most often used in technical analysis showing the average value of  of a particular currency  price over a set period of time.
  • Moving Averages are used to determine trend direction.
  • Moving averages are good in a sense that they tend to smooth out price fluctuations or “noise” as some forex traders would call it.

However, this smoothing of price fluctuations is really the greatest flaw in moving averages are-they lag.

Lagging forex indicators of which moving averages is one of them, are forex indicators where price moves first then they move some time later.

In other words, lagging forex indicators respond very late to price movement.

Click to enlarge  the chart below if you can see it properly…

4 MAIN TYPES OF MOVING AVERAGES

If you are using metatrader4 trading platform, you will notice that there are 4 types of moving averages and they are:

  1. simple moving average-The most commonly used type of moving average, the simple moving average (SMA) is calculated by adding and then averaging a set of numbers representing the market. The SMA is by far the more popular mode, and it is considered highly useful because of its smoothing effect.The SMA emphasizes smoothness, that is, it tries to smooth out the erratic behavior of the market in order  to see the trend. However, there are those who do not like the fact that the SMA lags behind the latest data point by nature of its smoothing, and they prefer to give more weight to more recent data points, as in the weighted and exponential moving averages.
  2. exponential moving average-The Exponential Moving Average (EMA) is calculated by adding the moving average of a certain share of the current closing price to the previous value. Exponential moving averages assign more meaning to the recent prices and less to the closing price from the period’s beginning. Thus it is faster at detecting a trend reversal. Naturally, and depending on the length, it can be more susceptible to market noise.
  3. smoothed moving average-A Smoothed Moving Average is sort of a blend between a Simple Moving Average and an Exponential Moving Average, only with a longer period applied (approximately, half the EMA period: e.g. a 20-period SMMA is almost equal to a 40-period EMA)
  4. linear weighted moving average-calculated by multiplying each one of the closing prices within the considered series, by a certain weight coefficient. Like the EMA, the LWMA assigns more meaning to the recent prices and less to the closing price from the period’s beginning. Thus they are faster at detecting a trend reversal, though it they can be more prone to market noise.

 

Moving Average Trading Strategy

 

WHAT IS THE BEST MOVING AVERAGE TO TRADE WITH?

The answer depends on what you want to accomplish. If you want a moving average that reacts quickly to price movements then you should be using either the linear weighted moving average or the exponential moving average.

 

HOW ARE MOVING AVERAGES USED?

  • to determine trend direction
  • if price is moving above a moving average, it means the trend is up. If price is moving below a moving average, it means the trend is down.
  • when two moving average cross(the faster moving average crosses the slower moving average), it may mean a new trend has
    developed.

 

ADVANTAGES OF MOVING AVERAGES

  • many trend trading systems and swing trading systems are made out of moving averages.
  • they tend to smooth out price fluctuations
  • used easily to identify existing trend direction

 

DISADVANTAGES OF MOVING AVERAGES

  • Moving Averages Are Lagging Indicators
  • Moving Average Trading Strategies And Systems will perform badly in ranging or consolidation (flat moving) markets or markets that wipsaw.
  • moving average can be subject to market noise.

Let me give you an example of these on the chart below:

Moving Average StrategyFrom the chart above notice that:

  1. around December, the EURUSD rose briefly above the 25 daily SMA and then also around February, the EURUSD briefly went below the 25 SMA. This is the problem of noise…which is a term used to describe price data that does not reflect the picture of the main trend and this usually happens due to small correction and volatility.
  2. around May, when the trend changed, the moving average did not show this trend until about 400 pips later until price crossed the moving average. This is what’s called the problem of lagging with moving average indicators…the price would have already made a significant move in opposite direction before the moving average will give you the signal.
  3. Notice also that around the May to August period the market was in a sideways movement in a very tight range of around 300 pips. This is the problem of sideways and noisy market. If you were trading using moving averages during this period, it would be quite hard to make profits.

MOVING AVERAGE TRADING PROBLEM #1: LAG

Moving average is a trend following indicator. It can only tell you when the trend has already happened. You cant forecast a new trend with a moving average because its a lagging indicator. You will notice that in the chart above the moving average was still rising whilst price hit the resistance level at around 1.4911 and went down by 400 pips plus.

How to fix the Lag Problem: Here are some options. Reduce the length (number of day etc) in the moving averages. This will make it more responsive to price movement because the shorter moving average is more responsive to price movement. Or use a more responsive moving average like the exponential moving average or liner weighted moving average.

 

MOVING AVERAGE TRADING PROBLEM#2: NOISE

One of the best things about using moving averages for trading is that moving averages are designed to smooth out the erratic price data so that you can be able to detect the trend and stay with the trend. However, even the best moving averages suffer from noise. This happens when the market has volatile price spikes and even short term corrections and this can make price escape out of the containment area of the moving average.

How to fix the noise problem: Here are some options. Apply more days/periods to the moving average and the result of this is that it smooths it out and make it less responsive for example: instead of using a 25 simple moving average, you can use a 50 simple moving average.

Opt to using simple or smoothed moving averages…this allows you to reduce the noise.

 

MOVING AVERAGE TRADING PROBLEM#3: SIDEWAYS MARKET

Nothing is so frustrating than trying to use a trend trading strategy in a sideways market! You stop losses do not stand a chance! Regardless of what type of moving average you use in a sideways market, they will not work effectively. There will be too many false signals. You are better of using range trading strategies instead of moving average trading strategies during a sideways market.

You see, the problem with sideways market is you can never know for sure until its happening. You cannot predict it in advance.

How to fix the Sideways Market:

If moving averages were to detect sideways market, that would be excellent but they cant! So you will suffer losses when sideways markets happen.  One of the best ways to keep out of trading sideways market is knowing what kind of period you are trading in. If you know that it is a holiday period the big money traders are on holidays, then obviously there will be less volume  and volatility in the market so the market will be in sideways mode. Or if you don’t know, the Asian forex trading session also tends be a sideways market but starts to trend when the london session opens and this trend generally continues into the US forex trading session. So knowing this kinds of information helps you in staying away from the markets as there is potential for sideways movement.

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