The use of moving averages in Forex trading is probably one of the most popular methods around. Whether it’s the 20 period, the 50 period, or a combination of different moving averages (9/30 is a popular combination), it’s hard to to see a chart without an average on it.
But does that mean they work? When I say work I mean do they really offer you an edge? What are the most effective moving averages?
In order to determine that, we should first understand how an average is calculated and the first thing we need is price. Since an average needs price to move first, it automatically qualifies as a lagging indicator which I am sure you already knew.
Calculating A Moving Average
Starting with the most basic, a simple moving average, all we have is an average of the X number of days it looks back. It could be calculated from the closing price or an average high, low and closing price depending on the settings you choose.
Keeping it relatively simply: a 10 day sma using closing prices (1+2+3+4+5+6+7+8+9+10)/10 = 5.5
As new inputs come, the first one is dropped and the cycle continues.
If we are looking at an exponential moving average, the calculation is different by taking the more recent data and giving it a higher weight.
Don’t get too caught up in the calculation because it is done for you but knowing how it’s calculated can give you an idea of how they are calculated. The question for you might be “if it’s just a mechanical computation of price points, where is the edge?”
Big Players Use Moving Averages In Their Trading
You’ve heard this over and over again: “Hedge funds love the 100 SMA” or something to that effect. How do you know? There has never been a study that I am aware of, and I’ve looked, where someone surveyed all the big players and asked them.
That seems to be one of those “truths” that gets tossed around without any documentation to back it up.
I’ve heard people talk about the “power of the 50 SMA” and how it serves up great trading opportunities. There is a way to use moving averages but thinking it gives any sort of edge by itself is, I think, wrong thinking.
Why 50? Why not 53? Why 20? Why not 32? It’s just an average of price and there is no magic number that is going to make you a profitable trader. The players may use them but they certainly would not use them as the backbone of a trading system.
There are common moving average settings people use but in now way are they the “best moving averages for day trading” or any type of trading.
Use Moving Averages For Pullback Trades
That seems to be a popular example of a trading system using moving averages of all look back periods. Is there an edge? Let’s think about it…..
As price advances and the calculations take place, price will pull away from the average. Fair enough. Price eventually falls and will, at times, come into contact with the moving average. Did the average offer support?
No. Price only met the average because either due to rapid decline and price or a consolidation, the average price of X look back period is getting close to the current price. That’s not to say the mean reversion is not a viable trading edge because it certainly is.
But it’s not the average the causes the edge. At the most, it gives a trader some type of foundation in order to not simply trade at all areas of the chart. It’s what you notice price do at the average that matters.
Look to the left of current price on your chart and see what type of formation or price action has occurred.
One question you read a lot is “what is the best setting for a moving average” and one thing people must understand is that there is no best setting.
Using a short look back period of 10 will obviously have the moving average closer to current price for the most part. Using a 50 period moving average will have the average further away and it cases of extreme movement, very far away. (There is a trading tip in there that I will cover in a moment)
There is no best setting that will make your trading more profitable. Do not waste your time looking for one.