Moving averages are indicators of prevailing market trends. These are considered reliable and objective as they are data-driven.
In this lesson, you'll explore how moving averages could help you spot market trends and find profitable entry/exit points.
Moving Averages represent the average price of the security over the specified period.
When traders use a moving averages indicator, they look at a price chart with smoothed price action. This makes market analysis and trend spotting relatively easier.
Moving Averages (MA) function to minimize, if not eliminate, market noise. Market noises are insignificant or random price fluctuations that confuse traders and prevent them from seeing the primary price movement.
The primary appeal of moving averages is their power to make trends stand out in the noisy financial markets.
A rising moving average shows an uptrend; otherwise, a downtrend prevails.
When you plot moving averages, it creates a band that either stays on top or below the price action.
A moving average below price action suggests a bullish trend. This is because the average price is relatively lower than the traded price.
In other words, the asset is trading above average – it's currently appreciating.
When the moving average is above the price action, it suggests that the price trades relatively lower than the average.
It generally indicates a bearish trend due to weakening asset prices over time.
Spotting trends using moving averages is too simplistic.
That's the common problem and dilemma of traders with Moving Averages.
It's too simple that it will be broken when market fundamentals, sentiment, or new releases influence the market.
Its simplicity makes it susceptible to fakeouts.
Read more: TradersUnited – Types of Forex Market Breakouts
To prevent falling from fake outs, profitable traders religiously plot multiple moving averages to spot trends effectively.
Doing so provides a clearer signal of the underlying trend of the asset.
The moving averages should be categorized into two – a slower and a faster MA.
If the faster MA moves above the slower one, it signals a prevailing uptrend. On the flip side, there's a prevailing downtrend when the slower MA moves above the faster one.
Simple Moving Average Formula:
SMA = A1 + A2 + ... + An / n
Trader John is analyzing the GBP/USD market. At first glance, the market seems to be in a downtrend. If valid, this signals a profitable short entry.
To confirm the prevailing trend, John used his knowledge of moving averages. He decided to get the 10-day and 15-day SMA of the GBP/USD market to understand the underlying trend.
| 1st to 10th closing prices | 1.2727, 1.2707, 1.2715, 1.2689, 1.2675 1.2698, 1.2680, 1.2668, 1.2640, 1.2660 |
| 11th to 15th closing prices | 1.2654, 1.2650, 1.2657, 1.2635, 1.2627 |
Following the SMA formula, John determined the following SMAs of the GBP/USD market:
Now, John plotted these two SMAs into his GBP/USD chart.
After a few moments, John noticed that the 10-day SMA was moving faster than the 15-day SMA. The 15-day SMA band is moving above the price action and the 10-SMA band.
With this moving average movement, John confirms the market's prevailing downtrend. What he should do next is analyze the strength of the trend—whether it's poised to continue its course or not.
Challenge yourself further on CommuniTrade
Keep up to date with trading news, trends, and analysis on CommuniTrade. Ask questions, verify facts, start thought-provoking discussions with fellow traders.