Moving averages: a powerful weapon in the forex trader’s arsenal

It’s estimated that more than 80% of all retail forex traders lose their shirts in the marketplace. For that reason, those novices new to this arena are wise to study, not only the wiles of individual currency pairs to learn their characteristics, but also the various technical indicators that can clue them in to range breakouts and potential profits.

One of the more powerful of these technical weapons, as I like to call them, is the moving average in all of its various forms.

A moving average is just what it sounds like. It’s the average of a chosen number of prices from a single currency pair within the forex market, with the average “moving” as the oldest price is replaced by a new one whenever the time period advances. A moving average can be calculated on any price—open or close, high or low—and over any number of time periods from three to three hundred. Once calculated, the moving average is graphed atop the chart of the currency pair under discussion, where it demonstrates whether that pair is responding to greater buying or selling pressure than during those preceding time periods.

There are many types of moving averages. The ones I personally use most often include:

• the simple moving average (SMA), which is calculated the way we learned in school, i.e., adding the prices together then dividing by the number of time periods, thus giving equal weight to all of the prices; and
• the exponential moving average (EMA), which gives more weight to recent prices over older ones in order to reduce the lag time, so the indicator reacts faster to changes in the price action’s direction.

See this chart?

This is a one-hour chart of the Australian dollar versus the New Zealand dollar (AUD/NZD), and it’s been remarkably volatile lately, giving forex traders many opportunities to take pips off the table. The green horizontal lines pinpoint long-term support and resistance levels, and what I want you to notice in particular is how the red and white average price bars bounce around between them for a while, then break out and either climb or drop rapidly. (This often happens when the volume, the green vertical lines at the bottom of the chart, is at a high level, but not always. The fourth rule in profitable forex trading is, there is no such thing as always.)

Now check out the two purple lines that seem to surround those price bars. Those are five-period SMAs, one calculated on the opening price and the other on the close. When a currency pair’s momentum is particularly strong, as it was during those times the pair broke out from between the green lines, those price bars will actually poke through the walls of that SMA channel. When the solid part of the bar pushes its way out, you know that’s a potentially profitable trade.

Here’s another chart:

This is the same chart, except the five-period SMA lines have been replaced with two ten-period EMAs, one calculated on the opening price (purple) and the other on the close (blue). Note that, when these two lines cross, it’s often (not always) at the start of a run, which doesn’t quit until the two lines cross again, an example of one potential EMA trading strategy suitable for these breakout runs.

The moving average is a powerful technical weapon and it’s one I intend to discuss often, but it requires a fair amount of experimentation and paper trading to determine the best combination of time periods for each currency pair. If you’re willing and able to put in that study time, great and what are you waiting for, but for those of you who don’t, here’s a link to a trading system that has a ton of potential.

And remember theforexwriter’s rules for trading:

1. Have a strategy.
2. Plan your trade.
3. Trade your plan.
4. There’s no such thing as always.

Happy trades to you.