Many traders use moving averages as support and resistance indicators, or focus on whether a candlestick has closed above or below a particular moving average. These methods are not necessarily the best way to utilize moving averages. They can actually be used much more profitably by treating moving averages as momentum indicators, indicating the strength or absence of a trend, in conjunction with other entry triggers. This is how they are typically used by Forex trading professionals.
Types of Moving Averages
There are several different types of moving averages and each should be understood before it is used. Almost every charting platform offers all types of moving averages. Note first of all that moving averages can be applied to the closing price, opening price, or the high or low prices of a time series. Typically, they are applied to closing prices, and this is logical as closing prices have great importance, and every opening price is also a closing price or a previous candle. Closing prices have great weight over samples because often it is a level where the price has settled.
So let’s look at each type of moving average.
The simple moving average (SMA) is just an average of all the periods that it refers to.
The exponential moving average (EMA) is calculated by giving greater weight to the most recent value. This means that for example if the price has been flat, but begins to rise, an EMA will be showing a level higher than an SMA covering the same look back period.
The linear weighted moving average, which is sometimes referred to as just as a weighted moving average (LWMA or WMA), is like the EMA also calculated by giving more weight to the most recent value, but the weighting is proportionate throughout the data series, whereas the EMA only gives greater weight to the most recent sample.
There are a few other types of moving averages. You do not need to worry about them. These three can give you everything you need.
Important Moving Averages
There are a few specific moving averages that are watched by a large number of traders. I’ll outline them here, but I suggest not to pay much attention to where the price is in relation to any of them, as if it were something important in itself. These key moving averages are:
Using Moving Averages as Momentum Indicators
One of the best ways to use moving averages like the professionals do is by using them as momentum indicators, to determine whether there is a trend, and how strong it is. The best edge that retail traders have available to make use of is to trade in the direction of a strong trend, if one exists.
One way to do this is to look at the angle of the slope of a moving average. For example, in a strong upwards trend, a lot of traders will be looking at the angle of the 20 EMA. If the angle is strong and consistent, it is indicative of a trend existing. Note how in the chart below, the 20 EMA is showing a reasonably strong angle, and also note that the price has mostly stayed below it all the way back on the chart. This is indicative of a downwards trend.
Moving Average Crosses as Momentum Indicators
A way to do this that is more sophisticated, is to look at whether a faster moving average is above a slower moving average, and to implement this on multiple time frames. When you have higher time frames showing a good trend but a pull back on the lower time frames, this might give you an opportunity to enter in the direction of the trend when the moving averages cross back in the same direction as the higher time frame or time frames.
A combination of moving averages that I like to use is the 3 EMA as a fast moving average and the 10 SMA as a slow moving average. There is nothing especially magic about these numbers – beware of traders who swear by something like the 42 period LWMA as a magic indicator – but the difference between them tends to give you an early alert of a change in direction. In fact, when I use this combination, I do not just use multiple time frames, I need to see the RSI 10 period indicator agreeing with the direction too. This kind of multiple time frame, multiple moving average strategy can be highly profitable.
In the sample chart shown below, these two moving averages on higher time frames are all showing the 3 EMA below the 10 SMA. In this 5 minute chart, while this condition existed within higher time frames, the 3 EMA pulled back twice before crossing back below the 10 SMA as indicated by the downward arrows. These two crosses could both have given profitable short term trades.
Deviation from Moving Averages
It is not appreciated widely enough that almost all trend indicators are based upon some kind of moving averages. For example, the Bollinger Band is just the 20 EMA in the middle with statistical deviation channels based upon the range of historical prices.
A very sophisticated way to use a moving average is to scoop up quick, high probability pips by the following method. Say a fairly short-term moving average such as the 20 EMA is showing a strong angle and the price generally holding above it. If the price very suddenly falls by a long way to now be below that moving average, there is a high probability the price will “snap back” quickly to rise back above it.
Another variation on this is to look for a candlestick that is not touching the moving averages at all, but is indicating a move back towards the area of the moving averages. For example, in the image above, the 8th candlestick from the right is an inside doji and is not touching the moving averages at all. This suggests that the price is going to at least pull back a few pips, as it did.