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2007-04-08 09:13:59
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Article by Sacha Tarkovsky |
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Moving averages are used frequently by forex traders and are a useful tool if used correctly.
Many traders however don't know how to use moving averages correctly and lose.
Here we will look at their advantages and disadvantages and how to apply them correctly.
There purpose
Moving averages (no matter what period is used) all have the same aim:
They identify trends over specific periods smoothing out the day-to-day price fluctuations that are simply caused by market volatility.
The equation is simple:
The closing price is added up and divided by the period of the moving average.
Popular moving averages
200 Day moving averages are popular for tracking longer term trends and 20 to 60 Day moving averages are used to identify intermediate trends.
5 to 20 Days are popular for short cycles.
Below you will find two common errors made by novice traders when trading with moving averages.
1. Using Them as a leading Indicator
When using moving averages novice traders frequently use them as a leading indicator to place trades in the market.
If using moving averages you need to understand this:
Moving averages are a lagging indicator NOT a leading indicator.
They therefore should not be used on their own to initiate new trades.
The fundamental error many traders make is to simply buy dips to the moving average and "hope" they hold.
Just like buying dips to support at a trend line (without evidence of a change in price momentum) this trading method leads to losses.
Moving averages should not be used as a leading indicator and you should time entry with a momentum indicator such as the stochastic.
2. Using moving averages in short time periods
We all have time frames we like, We personally use 18, 40 and 200 day averages to help us identify trends, but today we have seen a rise in people using moving averages in time frames that are simply to short.
Using moving averages for a few days or less is pointless.
I have even seen people using hourly moving averages!
This is crazy and recipe for disaster.
Many day traders use moving averages, but the periods are so short their meaningless and they give moving averages a bad name!
They lose and blame the indicator but it's their fault for being stupid and using the indicator incorrectly.
The correct way to use moving averages
Experiment with timescales, but you can use moving averages to indicate layers of support and resistance and alert you to a potential trading opportunity to trade.
You can with moving averages isolate areas to enter trades with good risk to reward and then time your entry with a momentum indicator.
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