This article provides an overview how every trader should use moving averages to improve and accelerate trading. Therefore we hope to offer the 3 hidden secrets of the moving average in forex. (but let us know if we missed one!).
The moving average is a great indicator primarily because of its simplicity, but also due to its ability to produce various types of analysis (more later on). This combination of simplicity and depth together with its other characteristics such as consistency (calculated the same way) and dynamics (moves along with price) make it a win-win for all traders.
The best moving average setting have great value in understanding the following scenarios:
- Whether there is a trend in play – In a trending environment price and various moving averages are aligned
- When there is a retracement or reversal occurring – In a retracement/reversal scenario price is headed back to the average
- Where there is a lack of a trend – In a range mode the (long-term) moving averages are flat or close to flat
But there are more (hidden) advantages to them! Before we dive into it, let’s discuss the criticism which is regularly given to moving averages. Traders usually point to the fact that moving averages are lagging and therefore not a worthwhile indicator. Nobody can dispute the fact that they are lagging, but it is a costly miscalculation if a trader discards moving averages as a viable indicator. By using the 3 hidden secrets of the moving averages together with multiple time frame analysis, a trader can greatly benefit from moving averages as an indicator.
Hidden secret # 1: great reversal / retracement targets and divergence
Moving averages are perfect targets when divergence occurs!
As price builds on a trend with either higher highs and lows OR lower lows and highs, the trend eventually reaches an exhaustion due to the momentum fading away with each subsequent newer higher or low. Read more here about divergence definition, divergence example, and its uses.
The interesting point is: did you have a particular target in mind when viewing divergence? (For reversal traders this could take profit place, for trend traders this translates into how long the filter is valid)
The hidden secret is that on average – when divergence appears – a trader can expect the price to retrace at minimum back to an intermediate moving average (anywhere between 100 and 150 ema).
Obviously, it’s possible that price can sometimes miss the moving average band. But only if price hits or comes close to these moving averages can a trader consider the divergence to be irrelevant for future price movements.
Hidden secret # 2: the dynamics of gravity and speed
Not everyone is a big fan of physics, and I am one of them as its tough material. However, gravity is a concept that has a simple effect on our lives: we stick to our planet Earth because of it.
Price and moving averages have a similar relationship to each other as humans with earth. Here is my modest explanation of physics: as humans gain speed, we can temporarily jump away from the planet despite the effects of gravity. When we lose speed, the gravity pulls us back to the Earth. The more speed we have, the further and higher can jump. The great basketball legend Michael Jordan is the best example.
The same can be said about price and moving averages. When the price has more momentum (speed), it is able to travel more distance away from moving averages before being pulled back due to the moving averages and gravity kicks in. When the price has a little momentum, it is unable to go far before the gravity of the moving averages pulls it back to its average.
The angle of 2 faster-paced moving averages and the difference between them will indicate whether the price has sufficient speed to break away from its average. The best moving averages for momentum readings are ones between 5 and maximum 40 ema. A trader could choose 5 and 10 emas for instance, or 10 and 20 ema or 20 and 40 ema closes. The gap between the 2 ema’s will indicate the momentum and hence speed of price. Our SMI momentum indicator would do the same of course, but with less effort on your side.
Hidden secret # 3: EMA’s = Quick Sand or S&R
The hidden secret # 2 part discusses the speed part of the equation. This section focuses on the gravity part. How does a Forex trader know whether gravity is in play and how strong it is?
The answer is simple: check the angle of the moving averages.
In this case, intermediate moving averages are in fact the best for representation of gravity. Anything between 30 and +/-80-100 ema would do well.
If the moving averages are FLAT and they have NO angle àmoving averages have a very high gravity pull and the price will have lots of problems trying to move away from the average.
If the moving averages are ANGLED and they are NOT flat àmoving averages have a very low gravity pull and the price will succeed quicker in trying to move away from the average. The moving averages, in fact, turn into dynamic support and resistance and when the price does get back to them, it can use these levels as a rough area for trend continuation (bouncing area due to Support and Resistance).
For some of you these “3 hidden secrets of the moving average” are known; for others, it could be new. Irrespective of that, what do you think of the above concepts and what are your experiences in trading?
We at Winners Edge Trading we want to provide the best content for your Forex trading and appreciate any and all feedback.
By the way, next time we will continue with our moving average discussion and explain how we can use the indicators on multiple frame analysis!
Please share your comments on additional ways to use moving averages that we did not mention.