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Technical Basics Lessons

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16

Trading with moving averages

Fri, Mar 20 2009, 13:07 GMT
by Valeria Bednarik

FXstreet.com Independent Analyst Team

As many of you already know, Forex is the most amazing and popular electronic financial market: it moves 1.5 trillion dollars a day, what NY Stocks market moves in a year. A 24 hours a day, 7 days a week market, with high volatility and liquidity, and with a plus advantage: leverage. A market where you can choose to go bull or bear with no cost: no extra premiums to pay, no additional options. It seems pretty much convenient, right?

Well, let me tell you the disadvantages before I continue: high volatility, liquidity, leverage. Yes, just the same: advantages are disadvantages too. All these things can play against you as well as in your favor, with an extra: Brokers. Most retail traders must use a broker, who will be the counterpart in all transactions as there is no way to directly deal in the interbank market. And, as brokers are market makers, they can widen spread, or even refuse to trade during particular moments or conditions.

So, why are we here? What makes Forex so attractive, so popular? Where is the DIFFERENCE? A non written rule says only 10 % of Forex traders are successful, against the 90 % who blow their accounts.

I remember, when I completed my technical course, my Master telling me: now you’re ready, you have all the tools you need, the tools most traders don’t have: you have technical knowledge, psychological training, and effective money management rules you can and now should apply. It took me pretty much a year to understand his words, but there is the difference: believe it or not, the “90 % losers” trade without using technical analysis, without a working plan, without nothing but the ambition to become rich in the short term. Most Forex traders trade by impulse following a hunch more than a trend. Using guts instead of indicators or oscillators.

Over the years I have been here, I've also discovered another difference: most traders spend their time looking for The System, the unique, the perfect one, of course one developed by someone else, instead of even trying to study two or three simple indicators; of course as soon as a system gives a bad entry, they discard it, and jump into another: the cycles repeats, and there goes their money.

One last word before diving in technical: remember here there is another important difference with other financial markets: time. For Forex traders, short term refers from minutes to a few hours. Traders can work and profit with 4 hours, 1 hour or even 30 minutes charts.

A simple and effective way to start with technical Forex trading is using Moving Averages: a Moving Average (MA) is a trend direction indicator that calculates a simple arithmetic average of prices for a particular period, showing the average value of the price of a currency over a set of values. There are different types of MA: we use SMA for simple moving averages and EMA for exponential ones. There are others kinds of MA (smoothed, linear weighted, etc) but we will limit this short study to the firsts ones, as they are the most used.

The SMA calculates the average of the price by dividing the sum of all the prices of the specified period by the quantity of prices.

If

x = close Price for each session

X = the number of sessions

The formula would be

SMA = Sum of “x” periods / X

Where x represent a certain number (it could be almost any number from 2 to 500 depending of how many historical information your charts include); besides, many charts allow to select a set to apply to the calculation: open, close, high, low, median or typical price.

The EMA smoothes the MA by adding the previous value to the current closing price and by giving the last prices more weighted value. This type of MA reacts faster to recent price changes than SMA.

Different ways to trade with MA

There are many different methods and settings of Moving Averages a trader can use; let’s see two basic methods, with some of the common settings, useful for intraday trading Remember that MA's work better in trend markets and are not reliable in sideways ones.

A basic trading system is to use a MOVING AVERAGE BREAKOUT. You have to start by drawing a MA in any chart. Let’s see an example in a 1 hour chart of EUR/USD. I used a SMA of 20 periods (blue). When the price crosses the Moving Average down-up and there’s a new candle opening above the Moving Average indicator, we buy; and when the price crosses the Moving Average up-down and there’s a new candle opening below the Moving Average indicator, we sell. Your exit signal will be the price crossing the MA in the other way.

But this is not as simple as it seems and not reliable enough: a Moving Average Breakout has to be combined with an indicator to act as filter. The filter reinforces the signal and increases the probabilities of a good trade. The best choices in this case will be Momentum or Stochastic Oscillator. Any of these two arithmetical oscillators will act as a confirmation of the trade.

Another and of course better way to trade MA is to use MOVING AVERAGES CROSSES. With this system, you can work with at least two MA, although some traders prefer to use three. The first one will be set with a small period (Fast Moving Average), the second one will be set with an intermediate number of periods and the third with the biggest number of all (Slow Moving Average). Let’s see an example using SMA of 4, 9 and 18 periods in a 4 hours USD/JPY chart:

The light green is a 4 periods MA, the medium, 9 periods, and the dark green is for 18 periods. See how, when 4 MA crosses 9 MA and then, both of them cross 18 MA. You have there a good trigger. The 4 periods line crossing the 9 one is the first advice you have; this signal gets its confirmation when both, 4 and 9, cross 18. Your exit will take place when the slow MA turns back crossing 9 in the other way. This is a quite reliable and simple system when market moves in trend; besides there are lots of combinations that can be used, using MA or EMA. As an example, a good combination with EMA is 5, 13 and 34. And, as in the first case, this system would become even better if you combine it with any oscillator to act as filter.

Anyway, the question here is not only the MA or EMA system selected; this will also depend on the time frame you choose to work with: a signal in a 30 minutes chart will not be as strong as one in a 4 hours chart. Also, the “life” of a trade will depend on two main factors. The first is the continuity of the signal: as long as the conditions that gave the entry signal remains the same, the trade is valid; as soon as any of these conditions disappears, you are getting the signal to close your trade. Second, we generally consider that any signal is valid for the next four candles; so if you are trading using a 30 minutes chart, your signal will be valid for the next two hours. After that time, we consider the trade should be completed; if not, then, again, you must close your position, as soon as any of the conditions that trigger the entry signal change bias.

As one of the main characteristics of the Forex market is volatility, traders are forced to use a tool that many dislike, but that is much more useful than you can imagine: stop losses orders. I understand it is really hard to assume a loss; I don’t understand why many people risk all their capital in a single trade, when Forex gives a lot of opportunities every day. This is a certainty; you will lose money in Forex. But as long as you trade using the right tools, losses are just another step in the way. Understanding the delicate balance of risk management is the secret of success here. Get rid of your pride, find a simple system you like and follow these rules; you will probably close more profitable trades than you can imagine.

Published on  Fri, Mar 20 2009, 13:15 GMT