Moving Averages Lesson 2

Moving Averages Outline

Welcome to Moving Averages trading Part Two, presented by Daily FX Education.

Moving Averages are one of the most popular, widely used and easy to implement tools
available in technical analysis. Their primary purpose is to smooth a data series to make it
easier to spot trends, something that is especially helpful in volatile markets. They also form
the basis for most other technical indicators and overlays.

In the first video we went over numerous aspects of Moving Averages. In this video we will
recap and elaborate on some of those and then move on to how to employ moving averages
in actual trading situations. Let’s begin by expanding on some of the areas covered in the
first video.

How moving averages are calculated

To review, moving averages recap the average closing prices of a currency pair over a
specified time frame.

On a Daily chart, for example, a 100 period moving average would be calculated by taking
the closing prices for the previous 100 days (or 100 Daily candles), adding them up and
dividing by 100.

Each time a new Daily candle closes it is added on the right side of the chart and is taken
into the average. As a candle is added on the right, a candle is dropped from the left side of
the chart, the 101st candle in this case, and the updated average is then plotted.

If we were to go down to an hourly chart with a 100 period moving average on it, we would
be taking the closing prices for the previous 100 hours (or 100 hourly candles), adding them
up and dividing again by 100 as we are still using the 100 period moving average. As was

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the case in the example above, each time a new hourly candle closes it is added on the right
side of the chart and is taken into the average. Additionally, a candle is dropped from the
left side of the chart, the 101st candle, and the updated average is plotted.

Here is an hourly chart of the EUR/USD with a 20 period SMA plotted on it. All the same
rules we explained regarding the 100 period moving average would apply except we are
now applying those rules to a 20 period moving average.

As a trader moves among the various charting time frames, the moving average is
recalculated with the time frame of the various charts each taken into account.

The differences between longer time frames and shorter time frames in the use of
Moving Averages

As a general trading rule, the longer the time frame of the chart employed, the more
reliable the data. Since a longer time frame chart will encompasses a greater number of
data points than will a shorter time frame, more reliable feedback can be obtained. he
same is true with Moving Averages.

A moving average which based on the previous 100 days of data will be offers greater
reliability for trading than will a moving average compiled using the previous 100 hours of
data.

Hence a 200 period moving average (the previous 200 candles) is more reliable than a 100
period moving average, the 100 period moving average is more reliable than the 50 period
moving average and so forth.

The most widely used Moving Average time frames

Since all moving averages are ultimately based on price action, it is reasonable to assume
that one moving average is as good as any other since they all are compiled from the same
price movement. Each Moving Average is simply viewed through a different "lens"
perspective of a different time frame...the lens of a different time frame.

The most widely used Moving Average periods are 10, 20, 50, 100 and 200. While any
moving average or series of moving averages can be set up and show how price had been
moving it is valuable to view periods that the majority of traders are viewing. As more
people buy a currency pair its exchange rate increases. As more people sell a currency pair
its exchange rate decreases. Therefore, using the same indicators and indicator settings
that the majority of traders are using, we can increase the likelihood that we end up on the
right side of the trade.

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 Moving Averages Lesson 2

This chart that shows how the 5 primary Simple Moving Averages compare to one another
on the same chart. We can see that the "fastest" of the 5, the 10 period SMA, is the most
sensitive to price action while the "slowest" SMA, the 200 period, is the least sensitive to
price action.

Again, utilizing the most widely used moving averages, traders can base their trades on
what the market is doing and what the majority of traders are viewing in actuality.

Simple Moving Averages vs Exponential Moving Averages

When a simple moving average is compiled, each period is given the exact same weight in
that calculation. The data going back 100 candles is evaluated in the same way that the
most recent candle is evaluated.

When using an exponential moving average however, the most recent candles are weighted
more heavily in the calculation. The thinking on this is that the more recent price action
has a greater value in determining the direction that the pair might move going forward and
reduce the lagging tendency inherent in Moving Averages.

EMA's reduce the lag by applying more weight to recent prices relative to older prices. The
weight applied to the most recent price depends on the specified period of
the moving average. The shorter the EMA's period, there is more weight that will be applied
to the most recent price. A 10-period exponential moving average weighs the most recent
price 18.18% while a 20-period EMA weighs the most recent price 9.52%. The important
thing to remember is that the exponential moving average puts more weight on recent
prices. So it will react more quickly to recent price changes than a simple moving average.
Whether or not this makes the EMA a more valuable trading tool than the SMA is open to
debate among traders.

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While the Exponential Moving Average is consistently closer to the actual price, the usage of
one over the other is largely dependent on the strategy being employed and, often, the
predisposition of the trader in question.

This chart example exemplifies the difference between the two Moving Averages on a Daily
chart of the USD/CAD pair. It can be seen that the two mirror price action in much the
same way but that the EMA is more sensitive to recent price movements than is the SMA.

The advantages of Moving Averages Advantage

There are many benefits to using using moving averages in your trades. Whether used in
combinations or alone, they graphically depict the direction that price has been moved.
When used in combinations (10, 50 and 100, for example) they can show on a single chart
how prices has been moved in various time frames. A trader can see at a glance how the
shorter, faster MAs are moving relative to the longer slower Mas. This comparison can be
beneficial in a trending market where the trader can observe price action retracing on a
shorter MA (a 10 period, for example), and take note of when the retracement has finished
and then enter the trade back in the direction of the longer MA (200 period).

On the Daily chart of the AUD/USD pair, we have three Moving Averages on the chart: the
10, 50 and 200. Based on the 200 SMA, we see that the pair is trending up. On the 10 SMA
it is moving against the overall trend of the pair, retracing down below the 50 SMA. If the
10 period SMA moves back above the 50 SMA, in the direction of the overall trend, it would
be signal an opportunity to buy.

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 Moving Averages Lesson 2

This example provides insight as to how moving averages can be used in trending markets.
They are put to much better use in trending markets as opposed to rang bound markets. In
a ranging market where the price action is not making does not make new highs and lows,
the MAs can become quite "entangled" and not really provide much usable data.

The disadvantages of Moving Averages

Many traders feel that moving averages "lag" the market more than other indictors and are
less precise than such indicators such as the Fibonacci tool, for example.

Since all indicators are based on an average of previous price action they lag the market to
a degree. When using a greater number of periods in the MA, the lag is more pronounced
but more reliable. When using a lesser number of periods in the MA, the lag is less
pronounced but less reliable.

Again, since moving averages are based on just that, averages, some traders feel they lack
precision of a Fib level which provides exact entry and exit levels. Keep in mind that we are
measuring two different things here. On the one hand, the MA provides a "running
average," or in other words is in a constant state of change. The Fib tool is measuring
measures something that is static in nature, a previously completed move in totality, so by
definition the results that will be provided will be quite precise since it is based on a
constant.

Moving averages when compared to other indicators, in my opinion, are no better or

Now we have reviewed moving averages, let's move into how they can be implemented in
specific trading conditions.

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 Moving Averages Lesson 2
These conditions will include how to use Moving Averages to determine support and
resistance levels, how to determine the trend, how to identify entries and exits and also how
to use moving averages in conjunction with other indicators.

How to use Moving Averages in Trading

Support and Resistance

The moving averages themselves represent levels of support and resistance. For example,
a trader puts a 50 period moving average on a chart. He observes how price action seems
to respect the bounds of the MA by not closing below it or above it depending on the
direction that the pair is moving. If that is the case, in an uptrend the trader can use the
moving average as a support line.

Each time the pair trades down to the MA, a long position can be taken with a stop just
below the 50 MA. (The reverse scenario would be true if the pair were in a downtrend.)
Also, this can be used as an exit strategy when the pair closes below the 50 SMA.

This scenario can be employed using any MA and following the same principles. Keep in
mind that the shorter MAs can be used in shorter term trading while longer MAs can are
more likely used in longer term trading.

One way to determine which Moving Average would best serve as a support level on a
particular chart is good, old trial and error. Place each of the major MAs (10, 20, 50, 100
and 200) on a chart and see which one, if any, consistently acts as a support level (or a
resistance level in a downtrend) and then use that Moving Average going forward to make
trading decisions.

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 Moving Averages Lesson 2

Also on this Daily chart it can be noted how, at different times over the trading history of
the pair, different Moving Averages have represented different levels of support for the pair.

Determining the Direction of the Trend

There are a couple of ways MAs can be used to determine the direction of the trend. The
first is simply by "eyeballing" the MAs on the chart. Let's say there are 20, 50 and 200
SMAs on this 1 hour USDJPY a chart. If price trades below each of those levels, clearly the
pair is in a downtrend.

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 Moving Averages Lesson 2
If price action was above the three Moving Averages, the opposite condition, an uptrend,
would be depicted on the chart.

More than one moving average on a chart affords the trader more insight as to how the pair
is moving. In the case of the USD/CAD chart, price action remains below the 200 SMA so
we know that the downtrend is still in place. As price action moves above and below the
two faster MAs, we know that the pair was oscillating on both the 20 and the 50 Moving
Averages. We can also see that those two Moving Averages are moving closer and closer
to the 200 SMA. Based on that, we can tell the strength of the downtrend is waning.

Should the faster MAs break above and close above the 200 MA we would begin to look for
upside potential in the trading of this pair.

If the moving averages are angling to the upside, we have an uptrend in place. If they are
angling and working their way to the downside, we have a downtrend in place.

The key MA in determining the trend movement is the 200 period SMA. As a general rule of
thumb, when price is above the 200 MA on a Daily chart, a bullish uptrend is in place. If
price is pulling away from the 200 MA, the trend is strengthening. If it is moving closer to
the 200 MA, the trend is weakening.

Using Moving Averages to determine entries and exits

Keep in mind that when using Moving Averages or any other indicator, the best signals are
those that are in the direction of the trend on the Daily chart. In other words, if a pair is in
an uptrend on the Daily chart, for a higher probability entry we would wait for the Moving
Average to move in the same direction as the trend.

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 Moving Averages Lesson 2

When using Moving Average to determine entries and exits, we mentioned earlier that if a
pair breaks above a MA on our chart, that can signal a buying opportunity while breaking
below an MA can signal a selling opportunity. We can also use the MA to determine where
to place our our stops will be placed. In an uptrend, the stop is placed below the MA that
was used for our entry. In a downtrend, the stop is placed above the MA that was used for
our entry.

If we have multiple moving averages on our chart, we can employ a slightly different
strategy for determining our entries and exits.

Here the 20, 50 and 200 period SMAs are on this GBP/JPY chart. In this case, in a
downtrend a short entry signal is generated when the 20 period SMA, the fastest of the
three, crosses below the 50 period SMA and below the 200 SMA to the downside.

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 Moving Averages Lesson 2

That indicates bearish momentum is in place. After the crossover takes place, the 20 MA
begins to pull away from the 50 and the 200, and while the 50 begins to pull away from the
200. This indicates the move is gaining in momentum. Anytime we see the angle of the
Moving Averages increasing and the separation between the Moving Averages increasing,
we know that momentum is picking up in the direction of the angle and the crossover –
meaning more price action will be covered in a shorter period of time.

Conversely, there is a buying signal when these three Moving Averages begin to cross over
each other this time to the upside. It also signals to exit any short positions on the pair that
the trader might still hold.

Using Moving Averages combined with other Indicators

Using Moving Averages in conjunction with other indicators can offers potential confirmation
on what the MAs alone can provide.

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 Moving Averages Lesson 2

On the GBP/CHF 4 hour chart, below we can see how the MACD can be used in combined
with Moving Averages. In two cases MACD confirms the action indicated by the Moving
Averages while in the third instance MACD provides an earlier indication of what price is
likely to do.

On the USD/CHF 4 hour chart with the RSI on it, we can see how the RSI signals a bullish
move ahead of the signal that would be provided by the 10 period SMA.

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 Moving Averages Lesson 2
Even though the Moving Average signals a buy after the RSI, by using the RSI signal to
confirm the Moving Average signal, the primary point to be learned here is that they both
do confirm a bullish move. In many instances it will be the "lagging" indicator that
provides the stronger confirmation since it is based on a greater number of data points.

Ultimately, it is better to enter a trade later and be right than to enter the trade early and
be wrong.

When using Slow Stochastics in conjunction with Moving Averages, once again it can be
seen that Slow Stochastics signals a short entry prior to the time that a candle closes below
the 10 period Moving Average on this 4 hour chart of the USD/JPY pair.

As you may have already surmised, moving averages are an integral part of many of the
indicators that traders currently use. For example, MACD, Stochastics and Bollinger Bands
all employ moving averages.

MACD employs a short term 12 day moving average and a longer term 26 day moving
average to arrive at the trading signals it provides. The middle line of the Bollinger Band
indicator is a simple moving average which moves between the upper and lower bands.
The upper and lower bands are derived from a standard deviation calculation that
determines the level they should travel above and below that middle line. Also, the two
lines comprising Stochastics are both moving averages as well. So beyond the more
straightforward manner in which we have been discussing moving averages, it is clear that
they play a more "in depth" role in the use of many of the technical tools that traders use
on a regular basis.

Taking the above and looking at it in a different way, we can also place a moving average
on an indicator that we already use to "fine tune" it even a bit more.

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 Moving Averages Lesson 2
Let's say that we have a 14 period RSI indicator on our chart. We can bring a moving
average into play by placing it right on the RSI and gain an additional trading signal as we
see how the moving average moves relative to the RSI.

Take a look at this chart with a 3 period moving average placed over the RSI...

On the chart, the RSI is represented in orange while 3 period Moving Average is in black.
We can see that when the RSI crosses over the 3 period SMA to the upside, price action on
the chart reflects this and there is a bullish move. Conversely, when the RSI moves below
the 3 SMA, a bearish move to the downside ensues. If a trader took a long position based
on a bullish crossover, they may choose to exit the long position on a bearish crossover.
The opposite would be true in the case of the trader taking a short position.

As you may have noticed, this is very similar to how the MACD indicator signals entries and
exits into trades.

To place a Moving Average on the RSI indicator itself right click on the RSI portion of the
chart, click on Add Indicator. Then, in the Add Indicator window that appears, click on MVA
for Moving Average. Then click on the Parameters tab to set the period of the MA to be
used. When that has been done, click OK and the Moving Average will appear on the RSI
itself.

Conclusion

Moving averages can be effective tools to identify and confirm trend, identify support and
resistance levels, and develop trading systems. Moving averages are trend following, or

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lagging, indicators that will are always a step behind. This is not necessarily a bad thing
though as we mentioned earlier. After all, the trend is your friend and it is best to
trade in the direction of the trend. However, currencies spend a great deal of time trading
in ranges, which render moving averages largely ineffective. Once in a
trend, moving averages keep you in, but also give late signals. Don't expect to get out at
the top and in at the bottom using moving averages. As with most tools of technical
analysis, moving averages are best not used on their own, but in conjunction with other
tools that complement them.

We hope you found this video helpful and we encourage you to attend one of our live
webinars on Moving averages with our course instructors. In the webinar, instructors will
relate to you what you have learned here to current market and trading conditions including
some patterns that may be in the process of forming right now. Instructors will field live
Q&A on the topic of moving averages.

Thanks for listening and we look forward to seeing you in the webinars.

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