When trading foreign exchange, a forex trader needs simply a handful of moving averages (MAs) or related indicators to construct a basic trading strategy. Most commonly, MAs show where support and resistance levels are located and can also indicate trends.
Common moving averages (MAs) include the simple moving average (SMA), which takes prices over a specified number of periods and averages them, and the exponential moving average (EMA), which prioritises values during the last two or three months.
The following forex trading techniques are based on these two elements. In this article, we discuss how to trade with moving averages.
Moving average trading strategy
This moving average trading method uses the EMA because it responds quickly to price movements. Follow these steps to implement the strategy:
1. On a 15-minute chart, plot three exponential moving averages: one with five periods, one with twenty, and one with fifty.
2. In addition to the price, five and twenty-period EMAs are above the fifty-period EMA; you should buy when the five-period EMA crosses from below to above the twenty-period EMA.
3. When the five-period exponential moving average (EMA) crosses below the twenty-period EMA and the price and EMAs are both below the fifty-period EMA, you should sell.
4. For a buy trade, place the initial stop-loss order below the 20-period EMA. Alternatively, you can place it roughly 10 pips above the entry price.
5. If you want to take it up a notch, you can adjust the stop-loss to break even after the trade starts making 10 pips.
6. Consider establishing a 20-pip profit target. If you're long, you can exit when the five-period falls below the 20-period, and if you're short, you can exit when the five-period rises above the 20.
As a foundation for their trading approach, many Forex traders use a short-term MA crossover of a long-term MA. Find out what works best for you by experimenting with different MA durations or time frames.
Moving average ribbon trading strategy
If you want to build a simple forex trading strategy around a gradual change in trend, you can use the moving average ribbon. It can be used with an up or down trend change, depending on your preference.
One of the main ideas behind the moving average ribbon was the idea that more is better when it comes to charting moving averages. The ribbon displays eight to fifteen exponential moving averages (EMAs), ranging from extremely short-term to long-term averages, on a single chart.
The resultant average ribbon is intended to show the trend's intensity and direction. A widening or fanning out of the ribbon, which occurs when the distance between the moving averages increases and their angle becomes steeper, indicates a strong trend.
The moving average ribbon, like other moving average methods, uses conventional crossover signals to indicate whether to buy or sell. There are a lot of crosses, so it's up to the trader to decide how many are suitable for a trading signal.
If you're looking for low-risk trade entries that could yield significant profits, consider an alternative technique. Below is a method that tries to capture a market breakout, which usually happens after a market has moved in a small range for a long time, in either direction.
To use this strategy, follow these steps:
1. When the price flattens out into a sideways range and all or almost all of the moving averages converge nearby, stay focused for a moment. When all of the moving averages are close to one another, they should appear as a single thick line with little distinction between them.
2. To circumvent the limited trading range, put a purchase order above the high and a sell order below the low. Activate the purchase order and set the first stop-loss order below the low point of the trading range. When the sell order is triggered, set the stop-loss order just above the range's high point.
Moving average envelopes trading strategy
Moving average envelopes can be found above and below a moving average, which are percentage-based. Foreign exchange traders are free to employ either a basic, exponential, or weighted moving average (MA) as the foundation for their envelopes; the kind of MA itself is irrelevant.
In order to find the optimal percentage, time period, and currency pair to use with an envelope technique, forex traders need to conduct tests. For daily charts, envelopes with time intervals of 10–100 days and "bands" with 1–10% separation from the moving average are typical.
Day traders typically use envelopes with a value lower than 1%. Depending on the volatility, you might have to adjust the settings every day, particularly the percentage. Adjust the parameters so that the following approach tracks the daily price movement.
Ideally, you should only enter the market when there is a clear trend in the price direction. As a result, it's the path that the majority of traders follow. Assuming the price is currently in an uptrend, you may want to consider purchasing when it nears the middle-band (MA) and begins to surge from there. When price action reaches the middle band in a severe downtrend and begins to slip away from it, it may be a favourable time to consider shorting.
Once you've initiated a short position, position your stop-loss one pip above the newly formed swing high. After you've entered a long trade, place a stop-loss order one pip below the newly developed swing low. When the price hits the lower band for a short trade or the upper band for a long trade, you might want to consider leaving. Another option is to double the risk and aim twice as high. For illustrate, aim for a distance of 10 pips from the entry point if you are willing to risk five pips.
Guppy multiple moving average
Two independent sets of exponential moving averages (EMAs) make up the Guppy multiple moving average (GMMA). Three, five, eight, ten, twelve, and fifteen trading days' worth of EMAs are in the first set.
According to Australian trader and GMMA creator Daryl Guppy, this initial set reveals the psychology and trajectory of day traders. We construct a second set of exponential moving averages (EMAs) using data from the last 30, 35, 40, 45, 50, and 60 days. We adjust the long-term EMAs when necessary to account for the characteristics of a specific currency pair. We aim to depict the actions of investors over a longer period of time with the second set.
A longer-term trend may be showing signs of fatigue if it seems to be losing support from shorter-term averages.
Moving average convergence divergence trading strategy
A moving average convergence divergence (MACD) histogram displays two exponential moving averages (EMAs), one with 26 periods and the other with 12 periods. An overlay of a nine-period exponential moving average (EMA) supplements the histogram. With respect to a zero line, the histogram displays positive or negative readings. The forex market most commonly uses the MACD as a momentum indicator, but it can also reveal the market's trend and direction.
Using the MACD indicator, one can construct a wide variety of forex trading strategies, such as:
- When the MACD and signal lines cross, you should trade. When the price is moving upwards (the MACD should be above the zero line), you should buy when the MACD crosses over the signal line from below, using the trend as a context. To short sell during a downturn, wait for the MACD to pass below the signal line (it should be below zero).
- If you're in a long position, get out when the MACD crosses back under the signal line.
- When the MACD crosses back above the signal line, you should exit a short position.
- When you start trading, if you are going long, position your stop-loss just below the most recent swing low. If you're going short, put your stop-loss order just above the most recent high swing.
Pros and cons of moving averages
Pros
Moving averages help traders to identify the direction of the trend
Traders can use them to identify potential entry and exit points
Moving averages are easy to calculate and apply
Moving averages can be applied to multiple time frames
Moving averages can be used in combination with other technical indicators to increase the accuracy of trading signals
Cons
Moving averages are lagging indicators, which means they are based on past price action
Moving averages can provide false signals in choppy or sideways markets
Moving averages can generate whipsaw trades
Moving averages may not be suitable for all markets
Traders may become over-reliant on moving averages and ignore other important technical indicators or fundamental analysis
Conclusion
What matters most is your trading style and how comfortable you are with it. The EMA issues more erroneous and premature warnings, but it also provides more frequent and early alerts. During periods of volatility, the SMA not only provides fewer indications, but also fewer incorrect signals.
As you can see, moving averages are a versatile tool with many applications. Once a trader grasps the significance of the self-fulfilling prophecy, the ramifications of EMA vs. SMA, and how to select the appropriate period setting, moving averages become a valuable tool in their trading arsenal.