By clmforex.com
The moving average has been a staple of the Forex trader’s arsenal since it was first described in statistics textbooks in the early twentieth century. The visual representation of several averaged price points, the moving average provides a smooth line that makes it easy to see at a glance whether the price is trending upwards or downwards. So critical is the moving average to Forex trading that its calculation is at the heart of several indicators, including the Bollinger Bands and the MACD.
Moving averages are useful because they lag the price. That is, a moving average will always appear either above or below it. If it is above the price, this indicates that the price has been falling. If it is below, it has been rising.
Forex traders use the moving average in many ways, the most basic of which is a simple trading system. When the price moves upward through the moving average, they buy, and when the price moves downward through it, they sell. This system has drawbacks, however, in that the price will often move through the moving average only to immediately reverse. This false signal is known as a “whipsaw.” To get around this problem, Forex traders devised another use for the moving average: the filter.
To create a filter, they apply a second moving average to the chart of a much higher periodicity. For instance, if the moving average that the trader is using as a signal is 14 periods, they might apply a second moving average of 100 periods. This second indicator lags the price much more than the first, and it gives the trader an instant insight into whether or not the price is in an uptrend, downtrend, or range. If the price is in an uptrend, then, the trader will not accept any sell signals from the 14 period moving average.
Forex traders can create a more complex moving average system with a built-in filter by applying three moving averages with periods such as 14, 28 and 56, where each proceeding instance of the indicator is twice as much as the last. In this way, the price can fall through or rise above the first, then the second and finally the third moving average. At that point, the trader can be fairly confident that a change in trend is occurring and can trade in the new direction.
Another way that traders use the moving average is to plot two of them, one slower than the other. For instance, one may be set to 12 periods while the other is set to 26. The result is that a signal is generated when the slower moving average falls through the longer. This is the basis of the MACD, or Moving Average Convergence Divergence indicator, which chart technicians use to determine trend strength, momentum and direction.
The moving average, humble as it is, is often the first learned but is generally quickly discarded when when more complex indicators are encountered. This tendency may be to the trader’s detriment as many more complex indicators are simply using moving averages in their calculations and displaying the results in various ways. These more complex data presentations, while potentially useful, can also make it more difficult to analyze the market efficiently.
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