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Learn the basics of moving average trading strategy

August 21, 2016 18:30

MA 1 1.png

Dear Traders,

The moving average (MA) is usually the first indicator that traders try out.

Yet it's also generally the first indicator that is removed from their chart.

Why is that?

One of the main reasons is that traders see that the moving average is lagging.

This is true, but it is crucial to note that moving averages offer numerous advantages for traders using technical analysis:

...advantages that clearly outweigh this negative.

So removing moving averages from your analysis, is clearly a mistake.

Want the specifics?

Well in simple terms, the extra value of Forex moving average strategy:

  1. is not based on overly simplistic and unprofitable approaches like late crossover entries
  2. is rooted in its ability to identify trend and momentum, to act as support and resistance and to clarify divergence.

free live education

MA for trend and momentum

The core value of applying moving averages in Forex, is the MA's ability to quickly determine the presence plus direction of trend and momentum.

Let me explain the three differences between trend and momentum.

  1. An overall trend occurs if price moves away from the long-term MA: higher (uptrend) or lower (downtrend).
  2. A short-term trend is visible if price moves away from medium MA: higher (bullish) or lower (bearish).
  3. Momentum is visible if price moves away from a short-term MA: higher (bullish) or lower (bearish).

MA 2 1.png

The best trending movements are when price, the short-term trend and the overall trend are aligned in one direction.

For an uptrend this means:

  1. price is above short-term MA, and
  2. short-term MA is above trend MA.

For a downtrend this means:

  1. price is below short-term MA, and
  2. short-term MA is below trend MA.

The chart lacks a trend or momentum, if price is:

  1. moving around the MA - called a correction, or
  2. going back to the MA's - called a retracement or pullback.

Corrections can unfold in two ways: passively or aggressively.

A passive correction is when price goes sideways and the moving averages catch up with price

An aggressive retracement is when price moves impulsively (quickly), back towards the moving average(s).

MA 3 1.png

My favourite MA settings

Specific Forex moving average settings are not a crucial factor for success or failure.

The difference between a 200 MA or a 190 MA, will probably not create a long-term difference in results.

That said I do have some favourite MA settings.

In my opinion, the best moving averages for Forex and other liquid financial instruments are:

  1. trend: 144 ema close; all MA's between 100 and 200 qualify
  2. short-term trend: 21 ema close; all MA's between 20 and 100 qualify
  3. momentum: 5 or 8 ema close; all MA's between 5 and 20 qualify.

I am a fan of Forex moving averages primarily because an MA is a dynamic indicator, which is recalculated after each new candle or bar.

Luckily, the recalculation of the MA is completed automatically by the trading platform.

Other indicators like horizontal lines or Fibonacci levels are static:

...because the price levels do not adjust with new candles or bars.

The hidden MA gem

MA's are valuable as support or resistance, when the market is trending and moving impulsively.

As the market gains momentum, price will still make smaller pullbacks along the way.

These pullbacks typically retrace back to either a shallow MA like the 8 MA or short-term MA like 20-40 MAs, before the momentum continues.

In these cases:

  1. the MA's turn into a solid support or resistance level, which
  2. often caps the light pullback from a further counter-trend movement.

My favourite approach to visualize support or resistance, is applying the same MA in three different ways including:

  1. 21 MA close
  2. 21 MA low
  3. 21 MA high.

MA 4 1.png

Together, these three MA's create a band or zone of support and resistance.

The biggest advantage of having three MA's act as support and resistance, rather than 1:

...is that the market tends to respect a rough range, rather than a single support or resistance point…

… so a price zone always has more value than a single price point.

It is important to note that the MA's will not act as support or resistance, if the market is in a large consolidation (lack of trend).

And when adding an MA, I recommend completing some back testing using Admiral Markets easy-to-use MT4 Supreme Edition.

It would also be wise to watch some of our webinars on moving averages.

MA's for divergence and reversal targets

Eventually the trend will end and a phase of either consolidation or reversal will start.

The chance of pullback increases substantially, once the trend loses its momentum:

...which creates a divergence between highs (in uptrend) or lows (in downtrend).

Divergence is a strong indication of either a pending retracement within the trend, or an end of the trend and subsequent reversal.

Whether price shows a shallow pullback or a full reversal, depends on:

  1. the strength of the support and resistance nearby
  2. the time frame where divergence is visible.

The MA can also be used in different ways, when price starts its counter-trend move including as:

  1. an entry for further trend continuation, or
  2. a target for a reversal trade.

Here are the concepts I use as a rule of thumb when applying my strategy to Forex trading.

  1. Lack of divergence could see price retrace to and bounce at a shallow 8 MA.
  2. A single divergence on a one-hour chart or lower will mostly create a slight retracement, which means that price could pull back to and bounce at the 21 MA.
  3. A single divergence on a four-hour chart or higher will mostly create a sturdy retracement, which indicates a good chance of price retracing back to and bouncing at the 144 MA.
  4. A double divergence should initiate a stronger pullback, which means that price pulls back to a 144 MA.
  5. Divergences on a multiple time frames will increase the chance of a reversal, which means that price could pull the 21 MA to the opposite side of the 144 MA.

MA 5 1.png

The above targets are of course rough indications, so it is important to:

  1. realise that the targets could be missed before the trend continues, and
  2. analyse each financial instrument on its own merit and context.

That's it for now.

Feel free to leave any feedback on this post, in the comments section below.

And finally, If you are interested in getting my MA that changes colour according to its angle - just send a message and I'll get it to you.

Cheers and safe trading,

Chris

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