Trading CFDs carries considerable risk of capital loss. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
A moving average is one of the most widely used technical analysis indicators used by professional traders to trade Forex and other financial assets across the globe. One the best features of moving averages are that using it correctly can help you filter out the randomness of the market and offers a smooth and gradual progression of the price on the chart, which helps traders to identify the underlying market trend.
In general, most Forex traders consider the market is trending upwards when the asset price is trading above a specified period of moving average. On the other hand, when the price drops below the moving average line, they consider the market has changed the trend, and it indicates that the market is now trending downwards.
Moving averages can help Forex traders identify if the market is in a range bound condition. Because when there is no prolonged directional movement in the market, the moving average line remains flat.
Figure 1: Slope of the Moving Average Can Identify the Market Condition
As you can see in figure 1, when the 8-period moving average remained within a tight range, the market fluctuated within a close range, but during an uptrend, and later during a downtrend, the slope of the moving average went up and down, respectively. While professional traders can identify the market condition without any technical indicators, beginners often use it to confirm whether the market is trending up or down and if there is no underlying trend in the market.
However, besides using moving averages to identify whether the market is trending or stalled in a range-bound state, professional traders also use moving averages to project future support and resistance levels.
There are two ways professional traders utilize moving average to find these dynamic support and resistance levels, which you can also learn and apply.
Figure 2: EMA 50 Acted as Strong Resistance on EURUSD During 2014
You can use a single moving average, like in figure 2, to find the “average” of the price, and use it as a dynamic support and resistance level.
In figure 2, we used a 50-Period Exponential Moving Average (EMA) on the EURUSD daily chart, which acted as a strong resistance over several months during the downtrend of 2014. Starting from July 2014, every time the EURUSD price retraced back to the EMA 50 level; it either got rejected after a minor penetration above the moving average line. But, the accuracy of the moving average was so precise that in two occasions, the EURUSD price could not penetrate above the moving average line, and it simply touched and resumed the downtrend.
If you have placed a pending sell limit order near these projected support and resistance levels based on the moving average values, at least two out of the four trades would have turned out to be winners, offering you a 50% win rate. With a risk to reward ratio higher than 1:2, you could have easily made some substantial profit out of this EURUSD downtrend in 2014.
Besides using a single period moving average, you can also apply multiple moving averages to identify and confirm a change of trend, then use the buffer between these two moving averages as a support and resistance zone, and apply additional entry methods to fine tune your market entry.
Figure 3: A Moving Averages Crossover Creates a Support and Resistance Buffer Zone
In figure 3, we have applied two Fibonacci sequence numbers, 13 and 21, as two Exponential Moving Averages (EMAs) on the chart. As you can see, once the EMA 13 crossed above the EMA 21, it confirmed the bullish trend, and as the bullish momentum accelerated, the distance between EMA 13 and EMA 21 widened. This distance between these two Fibonacci sequence EMAs created a support and resistance zone buffer, which acted as support as long as the bullishness continued.
After the first crossover, on two occasions the EURUSD price bounced off the buffer zone, but on one occasion, the asset price penetrated below the buffer zone, then swiftly resumed the uptrend. As we discussed earlier, placing a simple limit order around these dynamic support and resistance levels can offer some great risk to reward trades, but the win rate would be pretty low because you are just guessing what might happen once price touches the moving average buffer zone.
However, if you apply additional filters, such as a second technical indicator or price action to trigger your entries, you can quickly improve the win rate of your portfolio.
In figure 3, the last two trades after the crossover also produced a Bullish Outside Bar (BUOB) and a Bullish Pin Bar. If you had applied these two simple price action filters and executed only these two trades, your win rate would have been a 100%. How about that?
One of the reasons why moving averages often act as reliable support and resistance level is because of the concept of “self-fulfilling prophecy.” Since large market makers like banks and institutional traders closely watch these important moving average levels like EMA 50, EMA 100, EMA 200, and EMA 360, they place large pending orders around these price levels. Once a corrective retracement of a strong trend pushes the price level near these moving average levels, it triggers the large institutional pending orders, and the trend usually resumes.
Also, please note that other statistically significant numbers like the Fibonacci sequence, 8, 13, 21, 34, and so forth, are also used as moving average periods, as we applied in figure 3. Using moving averages as dynamic support and resistance is a time-tested method of finding good trading opportunities. However, it is always a good idea that you backtest using different period moving average on various currency pairs in order to fine tune your trading strategy.