4.12 Using Moving Averages for Trend Detection

 
How moving averages indicate the trends
 
One line you’ll often hear from us on these pages: ‘The trend is your friend’. The path to heaps of pips – ride the trend!
 
Apart from various usages, moving averages are used to identify trends, strength of the trend and possibilities of trend reversal.
 

Ways to use

 
  1. Single moving average and price-action combination
  2.  

  3. Two moving averages of different time periods
 

Identifying the Trend with Single Moving Average

 
A quick-and-dirty way to check out the trend on an Forex pair is to see where the price is in relation to its moving average.
 
If the price is continuously above the moving average, it means the trend is up. If the price remains below the moving average, thumbs down!
 
A trend can be considered very strong If the price-action stays above a very short-term moving average, say 5-period moving average. It is always better to use shorter time-frame moving averages to judge the short-term trend situations. 
 
In the candlestick chart below, the smooth line is the moving average which is initially rising in sync with the price. The trend is clearly up. Suddenly the price turns down and crashes through the moving average. This is an indication of trend reversal and a signal for short-selling. From there on it keeps going downhill, remaining under the shadow of the moving average. This action tells you that the current trend is now down. The opposite is also true that when price action breaks above the moving average, it is a signal for going long.
 
Moving average for trend detection on a Forex chart. 
 
Does that mean that you should buy whenever the price crosses up from below the moving average or sell when it shifts gears downwards through the moving average?
 
We hate to tell you that it’s not always so easy! You see moving averages are prone to deliver false signals. A sudden fall or rise may take the price through the average, and the trader may be suckered into thinking that a new trend has started. The spike may be just that – a spike, with the trader watching in horror as the price just reverses right back and resumes the original trend, snatching away some of his precious pips.
 
Moving average in a downtrend giving false signal for the Forex pair. 
 
So, what’s to be done?
 

Identifying the Trend with Two Moving Averages

 
The secret is to use more than one average.  When the faster average is positioned above the slower one, the trend is ‘up’. When it is below, the trend is ‘down’. 
 
In the illustration below, for example, the two averages used are a ‘faster’ one of 5 days, and another ‘slower’ one of 55 days. Please note that if you are trading with an hourly chart then these would be 5 hours and 55 hours moving averages. We can simply call these as 5 period and 55-period to make these independent of the time-frame of the chart. See how the 5-day average remains above the 55-day average during the time the price was trending up. 
 
Use of 2 moving averages for ongoing trend detection and trend reversal. 
 
Please note that it is just an example and it is not suggested to use only 5-period and 55-period moving averages. In the later lessons we will cover this topic but just as a hint, please note the following:
 
Use two moving average with wide difference in the time-frames for long term trends and log-term positions and when your risk appetite is high.
 
Use two moving averages with narrow difference in the time-frames for short-term trends and short-term positions and when your risk appetite is low.
 

 

Time-frame  difference

 

 Pros  Cons
 Wide

 

You can take advantages of long-term trends for higher gains.

 

Indication of possible trend reversal is delayed and risk is higher.
 Narrow

 

Indication of possible trend reversal comes early hence the risk is low.

 

You may close your position sooner than required and miss the opportunity of higher gains.

 

The above chart with two moving averages is a fairly reliable snapshot of the trend. Improve it by combining with other tools such as trend lines and channels.

 

Similarly if the faster moving average remains below the slower moving average, it reflects a downtrend.

 

    

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