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The Magic of Moving Averages

Probably, the first indicator you have seen and used when you first started to trade Forex was a moving average. For me, it was that. Moving averages come in several forms — simple, weighted, exponential, smoothed, and other. They present the most basic way to measure the current trend direction and to spot its change. At a first glance, a simple moving average indicator looks like a miraculous tool that is easy to use and can tell you where to enter a position and where to exit one. Let's try to understand this indicator — is it really as good as it seems?

What moving average shows? No matter if it is a simple, exponential, or any other form of MA the only thing it is showing is the average rate of the currency pair over a certain period of time, hence the name. For example, MA with a period set to 7 on a daily chart for any given bar will show the average price over the previous 7 bars (days). This is not magic, right? Various forms of moving average just change the way the average value is calculated (to make the line look more smooth or sharp, or to throw out spikes), but in the end, we get the averages of the previous periods.

So, what happens when the current price crosses MA? Faster MA crosses slower MA? Three MAs cross each other? The cross of the MA and the price or another MA (or any amount of other MAs) is usually considered as the buy/sell signal or at least a partial signal. Why? Because they really show a change in the trend. The problem is that the change could have happened long ago (up to the MA's period bars ago). When the moving average is crossed by the price from below, it simply means that the current price became higher than the average price for the last N bars (where N is the period of the MA) — this is it and nothing else. If MA with a period of 7 days crosses MA with a period of 14 days from below, that means that the average price in the last 7 days is higher than the average price during the last 14 days (the actual trend change here could have happened up to 14 days ago). Some strategies employ a crossing of up to five moving averages — that will not change the fact that the only thing you will know when such a cross occurs is the ratio of the average price over five different periods.

So, is there any point in using a moving average? Yes, I think that a moving average is a good technical indicator, but not as a signal producer or a trend change detector. What does it do best? It indicates the average price. So, it is better to use it when you want to know the average price over a certain period. You can compare current price to the moving average to consider overbought/oversold state, measure the volatility by comparing the price action with the large-period MAs, use the long-term moving averages as the support and resistance levels (because so many traders and even proprietary trading shops use it this way), and so on.

Maybe, this is not a pleasant thing to know if you base your trading strategy on moving average crosses, but the facts do not lie, and as your trading experience grows, it will become clear to you that moving averages cannot perform any magic tricks and should not be used as an easy way to create yet another Forex strategy.

Nevertheless, a moving average remains practically an extremely reliable indicator as traders can experiment with the settings and try it out on different timeframes, finding out the use cases for it.