Another way of determining the trend is through the use of moving averages. However, moving averages are calculated from price in a manner that makes it a lagging indicator.
The main purpose of moving averages is to tell you what the trend is over the past. Moving averages are usually calculated using the average closing price over the past x number of periods. The longer back you look, the slower the moving average will move. The shorter the period, the more “sensitive” it is to price changes.
With moving averages, their sole purpose is to tell you the past trend. But what happens is that traders start using different numbers to try and find the “Holy Grail” of trading, thinking that when they find the right number, moving averages will magically tell them how to make money all the time.
In the end, what happens is a chart could potentially look like this:
It looks really beautiful, but how do you know which moving average is price going to bounce off?
You can see that the shorter term (red) moving averages move faster than the longer term (magenta and yellow) moving averages. That’s because that’s what moving averages do.
Using Moving Averages
That doesn’t mean that moving averages are totally useless.
It just means that when you place moving averages on your charts, they tell you what the average price has been in the past. And as the current price changes, the moving average follows the price and changes accordingly.
Whether you use a simple moving average or exponential moving average, they all basically tell you the same thing. Some moving averages will place more weight on more recent data, other moving averages will place equal weight to all price data. There is enough information on the internet for you to understand what simple, exponential, weighted moving averages and so on are, so I won’t go into the details of calculating the different type of moving averages.
When you use moving averages, you are attempting to identify what the trend has been in the past, and then trade in the direction of that trend hoping that the trend will continue. And when a trend starts, they usually last longer than people expect them to.
If you are a short term trader, when prices are above the short term moving averages you will want to favor long trades. And when prices fall below the short term moving averages, you will want to favor short trades.
For example, a 30 day simple moving average (SMA) on the USDJPY. When prices are above the 30 day SMA long trades are favored. When prices are below the 30 day SMA, short trades are favored.
If you are a long term trader, when prices are above the long term moving averages you would favor long trades. And when prices are below the long term moving averages, you would favor short trades.
Using a 200 day exponential moving average (EMA) on the USDJPY, you can see the same information. The difference of course is that there is a “lag time” when prices move from above the 200 EMA to below, and vice versa.
Moving Average Crossover
You could also use moving average crossovers to indicate a change in trend. When the shorter moving average is above the longer moving average, the trend is up. When the shorter moving average is below the longer moving average, the trend is down.
In the yellow zone, the 30 day EMA is below the 200 day EMA. In the green zone, the 30 day EMA is above the 200 day EMA.
Summary About Moving Averages
You can come up with many ways to tell a trend using moving averages. Instead of using the closing price to calculate the moving average, you can use the high, low, open, median price, typical price and so on. There are so many ways to calculate a moving average that a novice trader can easily get lost and confused.
But now you know the main purpose of a moving average, and that’s to calculate the past trend!
Personally, the simpler a trading system is, the more I like it. When it gets too complicated, it creates more room for error, and it’s never guaranteed anyway!
So when you look at moving averages, you now know that moving averages are used to calculate past trend, and not the future.
Trading Systems Using Moving Averages
If you are looking to trade forex trends using moving averages, this is a solid trading system you can look at: