As we touched up on in the previous chapter, you can use moving averages to determine trend direction in Forex by looking at how the indicator interacts with price.
And the easiest way to do this?
When price is in an uptrend, the moving average moves below the price action.
As the moving averages expand further from price, it indicates a strong uptrend a head. However, if the moving averages moves in between price, the trend is becoming weak.
Let’s take a look at an example below.
On the other hand, when price is in a downtrend, the moving average moves above the price action.
Therefore, if the moving average moves away from price, expect a strong fall of price (downtrend).
If the moving Average moves between price action, the trend is getting weak and is likely to change course.
Let look at an example on the chart.
When the trend line is broken, we would consider this to be a trend reversal.
Let’s say that EUR/USD has been in a downtrend, but an important report comes out causing it to surge higher.
On a chart, it looks like this.
You can see the price is ABOVE the moving average.
What would you do in this situation? Would you buy or would you wait?
In our example, traders reacted to the news but afterwards the trend continued and the price kept heading lower!
But don’t worry, there is a way to protect yourself from getting faked out.
What some traders do, and what we suggest you do as well, is that you plot a couple of moving averages on your charts instead of just ONE.
This way, you’ll get a clearer signal of whether the pair is trending up or down depending on the order of the moving averages.
Let us explain.
In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa.
For example, let’s say we have three MAs: 13-day (short-term), a 55-day (medium-term) and a 150-day (long-term) MA.
In our chart, you can clearly see that the shorter moving average (13-day MA) is more sensitive to the current price and will therefore always stay closer to the price in comparison to a longer moving average.
Notice that the 13-day moving average on the chart is the line that most closely mirrors the index movement. The line furthest away from the price is the 150-day moving average.
Another thing to consider when assessing the strength of the trend when using multiple moving averages is whether two moving averages are moving towards each other or moving closer together.
For example, in the chart above, in the second half of the chart you can see the red moving average moving further away from the blue moving average (i.e. the difference between them is increasing), which demonstrates how strong the current trend is.
By combining this with your knowledge on other technical indicators, this can help you decide whether to go long or short on a currency pair.
But more on that later. For now, why don’t you have some fun with plotting different MAs on your chart and see how they change overtime!