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The author looks at ways of profiting from trends by using Moving Averages.

Identifying and profiting from trends can be at times divergent topics and this dissociation can easily translate to losing trades.  While trend analysis, as defined by trend and channel lines, ratio and extension analysis is vital, traders should also go beyond pattern recognition and employ quantitative methods of analysis.  One of the most popular tools is moving averages.

What Is a Moving Average?

A moving average smoothes market swings, as some traders prefer to keep the statistical noise at a low level. To calculate a simple average, simply determine the arithmetic mean. To make an average move, just add the last price of the period of you choice, while deducting the oldest price. Traders should keep it in mind that the more days you use, the more insensitive the average will become to the current price action. 

Electronic charting services will generally allow you to average several prices of the period of your choice, such as opening, high, low, midpoint and closing prices. The averages, like all the other analytical methods, were developed for daily prices.  To this day, most traders use the closing price for averaging because it is the most important price of the day.

What Type of Tool is a Moving Average?

A moving average is only a lagging indicator.  This means that this tool is about the last one to react to a change in the current currency price, so don’t expect it to be a trail blazer. 
Another important thing to keep in mind is the fact that moving averages are working at their best only in trending markets.  Consequently, traders should diminish their usage of the averages in sideways markets.

Reasons to Use Moving Averages

Many traders tend to have biases when using moving averages.  For improved trading ability, it is important to know all of their uses.

Some will like a smoother view of the currency; it’s a valid point, but not a money maker.
Once one moves into the applied analysis, a trader should consider moving averages as flexible support and resistance lines.

The intersection between the market and a short moving average, perhaps between 10 and 30 days, should provide good buy and sell signals during trending markets. For instance, in Figure 1, the intersections between the euro/dollar and the 25-day moving average provide two buying signals (blue arrows) and a selling signal (red arrow).
The idea is to go long the currency when it crosses above such a relatively short moving average and hold that position – if in a trending market – for as long as the currency holds above this average.  In reverse, a downward crossover between the currency price and the support of a moving average on a closing basis suggests that the trader should short that currency.

Figure 1.  The intersections between the daily euro/dollar and the 25-day moving average provide two buying signals (blue arrows) and a selling signal (red arrow). (click to enlarge)

Another reason to employ moving averages in your work is the overbought and oversold signals that may occur when compared to the currency.  If the underlying currency and the moving average are trailing too far away from each other, this is a warning that the currency might change direction. However, a divergence on its own is a condition, not a signal, so use a trigger from a different source, such as the break below a support or a trend line to act in the market.

As Figure 2 shows, the euro/sterling cross is well above its 25-day moving average in two instances, in both case to the left of the vertical lines.

One way to lessen the overbought condition is for the currency pair to trade sideways, giving time to the lagging averages to catch up.