Introduction
In the previous lessons, we have understood the two types of Moving Averages and the difference between them. We have also seen which Moving Average should be used in different market conditions and the one that must be preferred most of the time. From this crouse lesson, let’s explore the real-time applications of Moving Averages and how we can find accurate trades using this indicator.
One of the simplest, yet important use of Moving Average is to determine the direction of the trend. This can be done by plotting the indicator on the chart and then deciding the position of candlesticks with respect to the line of Moving Average.
The ideal way of identifying a trend using MA is this – If the price action tends to stay above the moving average line, it usually signals an uptrend. Likewise, if the price action remains below the moving average line, it indicates a downtrend.
This approach of establishing the trend is too simplistic and also has a significant drawback. Let us understand that with the help of an example.
Below is the EUR/USD price chart, and we have added a 10-period MA line to it. According to the rules of MA, since the price is above the MA, we should be going ‘long’ in this currency pair.
Due to a news event, price drops suddenly and closes below the MA (in the below chart). So, this changes our plan, which means now we should be thinking of going ‘short’ in the currency pair. But before we do that, let us see what happens to the price in the next few candles.
The below image shows that the price fakes out and does not continue its downward trend. Hence, if we would have gone short, that would have resulted in the price hitting our stop-loss resulting in a loss. Let’s understand the problem with this setup.
The strategy mentioned above is right, but the problem is that we are using a single period MA line stand-alone and not combining it with any other indicator. The best way to use MA for determining a trend is by plotting an extra Moving Average line on the charts instead of just one. It will give us a clearer idea if the pair is trending up or down depending on the sequence of the MAs.
The best way is to check if the ‘faster’ moving average is above the ‘slower’ moving average for an uptrend, and vice versa for a downtrend. In the below chart, we can see that the ‘faster’ SMA is above the ‘slower’ SMA, and this shows the strength of the uptrend. Also, the fake-outs that happen because of news releases will also have less impact on the indication given by the Moving Averages. Combining this knowledge with trendlines can help us decide if we have to go ‘long’ or ‘short’ in the currency pair.
Conclusion
Moving Averages can be useful for establishing the direction of a trend, but it should never be used stand-alone. If not other indicators, additional moving averages itself can be combined with an existing moving average to decide the direction of the trend. In the next article, we will be discussing how we can enter a trade using moving averages and profit from this indicator. [wp_quiz id=”65733″]
