There is this saying in forex that “the trend is your friend” and a forex trader shouldn’t trade or go against it. This poses a challenge to all traders who trade on the financial market on “how to identify a trade direction”. Before we proceed further let’s briefly discuss what a trend is.
What Are Trends?
Every forex trader must have heard this word “TREND” at least once in their forex trading career and unfortunately most traders do not know the full perception. A trend is the movement of price in a particular direction for a particular period of time.
A trend can be classified as either a long term trend or a short term trend; I will stop here as this article is not about trends but on how to identify one.
Over the years, there have been discoveries on how to identify trends, either through using pivot points, Fibonacci series, Elliot waves, harmonic pattern etc. but we are not talking about any of those stuffs today instead we will be looking at “How To Identify Trends Using Simple Moving Average”.
What Is A Simple Moving Average (SMA)?
A Simple Moving Average or SMA is an indicator on a chart that shows trend direction at a glance. It is commonly used in the Foreign Exchange Trading aka Forex and The Stock Market and on some other financial markets such as the future market.
The Simple Moving Average can be customizable; the wonderful thing is that is can be incorporated into your style of trading. With that being said, Simple Moving Averages can be added to your trading platform either on mobile, tablet or your personal computer.
Mostly used on The Meta Trader 4 trading platform to identify a trending, flat or reversing market. Simple Moving Averages can be used to detect the direction of a trend and delineate potential support and resistance along with pull backs.
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Being able to flip through various pairs and find those that are trending at a steady rate is the reason why traders most times use Simple Moving Average.
When the Simple Moving Average also known as SMA is pointing up, it is indicating an upward or bullish market meaning that there are more buyers than sellers. When it is pointing down it is showing a bearish market as there are more sellers than buyers, which in turn shows a downward trend.
The SMA can also show traders in a glance whether the market will soon reverse or will continue its initial direction.
When SMA is flat it is an indication that there is low volatility either by indecisiveness or by lack of interest to the buyers and sellers at that specific time. Simple Moving Averages is just like any other indicators provided by a broker and will lag or be a little behind.
So do not think because a pair is ranging up or down that you can just jump in and enter an automatic winning trade. If this was the case we would all be billionaires by now. Further care and analysis need to be taken into consideration to be able to enter into a trade early and exit at the right time too.
The SMA is based on past data that is calculated by adding the last x amount of periods or candles of a closing price (or whatever price data you wish to use) then dividing that by the x number.
We will not bore you too much with the mathematical concept of how a moving average is composed but, will give an example of the most commonly used simple moving average. For example If you plot the simple moving average of 200 simple moving average on a 1-hour chart, you would add up the closing prices for the last 200 hours and then divide that number by 200. Now you have plotted your 200 simple moving average on your 1 hour chart calculating the last 200 price movements and coming up with a mean and so on.
As mentioned before SMA are slow and are lagging indicator just like most indicator provided by broker, that is why using technical analysis is very crucial to trading any strategy either created by you or by someone else.
This lagging is due to the fact that Simple Moving Average on a chart is based entirely on previous price data while giving a prediction where future price might be heading too. These Simple Moving Averages can give a hint which might be true and sometimes might be bogus and one cannot simply just jump into a trade based on it pointing up or down.
How does the simple moving average work?
Knowing about the SMA’s is good enough but knowing how to use them is better, using them is relatively easy as most brokers do provide them free for their client and no calculation is required.
A trader just has to set the following parameter when using the indicator (SMA):
- Period: the period here entails on how far into the past should price data be collected, remember that choosing 10 for example means that 10 candle stick data (the opening price, closing price, highest price or the lowest price) will be used in calculation.
- Shift: normally people use 0 as the shift, but the shift means which candle stick should be exempted, 1 means the first previous candle stick and 2 means the second and first previous stick should be exempted etc.
- Method: we will use “simple” though there are many options such as exponential, smoothed and linear weight but for the sake of this article we will use “simple” which denote that it is a simple moving average.
- Apply To: apply to here indicate which price data will be used for calculation example we have the ”close” we means that the closing price of the candle sticks will be used for the calculations.
Choosing which period to use can sometimes be quite confusing as such, I will use the 200 SMA as example since it is the widely use period by analyst.
The 200 SMA is normally used for plotting long term market trends on higher time frames specifically for swing trading. Some traders enter into a trade at the crossing of price from the 200 SMA either from below or from above and exit when price returns to the SMA.
Some people go as deep as including a 100 and 50 SMA and enter into a buy when a candle stick break through the 50 and 100 SMA period from the bottom and enter into a sell when a candle stick break through from the top.
In summary, remember that the market does not move in one direction neither does it moves in a straight line. One must be patient enough to go through some drawdown (losses) before entering into profit.
Also very important, a stop loss is always recommended whenever using any strategy as you try to maximize your risk to reward ratio, as no can see into the future to determine which will be either a losing trade or a winning trade but we can use our mathematical model to predict a bit about the future based on probability.
The Forex market does not just move in one upward or downward direction, it moves up down and even sideways. One has to seek further knowledge of events and technical analysis to minimize risk of losing your investment as the Forex market can be brutal to newcomers. Never lose hope as with a bit of help and guidance you too can actually become profitable in the foreign exchange market.
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