| Moving Averages in a Technical Forex Strategy |
 Moving average lines are the subject of criticism from technical and fundamental traders alike. “They're antiquated” or “they lag behind price and cannot forecast future moves” are common critiques of this technical tool. In one respect, these critiques are correct: moving average lines do lag behind the price. A simple moving average (SMA) line is formed by the sum of price closes in a given period divided by the length of time of that period. An exponential moving average (EMA) line is similar to an SMA line, but the most recent price closes are weighted more heavily. So, what use are average lines that essentially follow a price's footsteps in a Forex strategy? They are of great use. EMAs and SMAs provide support and resistance soft zones, give continuation and reversal signals, and can forewarn a trader of price/momentum divergence.Some common SMA and EMA lines are the 10, 20, 35, 50 and 200 day lines (Note: “day” can be substituted for any time frame; 5 minute periods, hourly, two hour periods, four hour periods etc.). Think of EMA and SMA lines as a place on a chart that represents “temporary equilibrium”. A rallying price will not head straight up and forever as it must pullback to find additional buyers. Moving average lines represent a soft zone where price can retreat to before buyers reemerge. A price that strays too far from its lagging moving average lines signals an overbought (or oversold) market. It is important to note that moving average lines are not concrete support/resistance zones such as a Fibonacci retracement levels or trendline support/resistance. What they can do is give the trader an idea of when a price is too expensive for a market, and when it is too cheap. The direction of these lagging lines is also of great importance. Upward facing lines below the price confirm a rally (and the opposite for sell-offs). Price behavior at these lines can also give a continuation signal of a move. For example, a price that is trading above an upward set of moving average lines that fails to sink below the lines on a pullback indicates budding strength in the rally. Conversely, a price that quickly takes off upward while its moving average lines are either flat or downward should be met with skepticism. Forex is known for its periods of extreme volatility where price can scream upward, only to reverse minutes later. A Forex strategy that incorporates moving average lines will prevent the trader from chasing these false moves (aka head-fakes). Moving average lines also aid in identifying exhausted rallies and sell-offs in the Forex market. Let's say in our previous rally example that the price continues to make fresh highs, but the moving average lines start to flatten out. The moving average lines are indicating waning momentum despite the fresh highs. This phenomenon is known as “divergence”, and is a warning that a steep correction or even a reversal is ahead. This is a signal to the Forex trader to step back and either wait for a lower price to enter, or to assume a short position once the market top has been confirmed. Which moving average period or combination of periods to use is best left to the trader's personal style. Experimentation through practice accounts is the best way to establish which set of moving average lines fulfills each individual trader's goals. What is important is to implement them into a Forex strategy, as they do give signals of future price moves despite their reputation for “lagging.” |
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