Moving Averages’ Help in Trading Decision

As with all trend-following systems, the signals from the moving average indicator work well when the stock develops a strong trend, but are ineffective when the stock is in a trading range. Signals generated by moving averages tend to be late as they come after a move has begun. That is why, as a trend following indicator, the moving average is best for identification and following, not predicting.

How to use moving averages?

The moving average's main function is trend identification and confirmation. There are some basic techniques a technical trader can use to identify if a currency pair is in an upward or downward trend.

• A technical trader can simply examine the direction of the moving average for significant upturns or downturns.
  
• A second technique is to see the price location. If the price is located above the moving average than the currency is in an upward trend, if the price is below the MA then the currency is in a downward trend.
  

As mentioned before, in order to use moving averages successfully the currency needs to have enough characteristics of trend. Moving averages are effective when a currency is trending and ineffective when a currency moves in a trading range. Let's look at a visual example of what this means.

In the figure above the 20 period (day) moving average is able to follow the clear trend for May and June. After that time, the three black boxes show times when the currency is moving in trading ranges that are too volatile for the moving average to pick up accurately. During a trading range, a price may move above the moving average indicating an upward movement, but then turn back down and fall below the moving average, implying a downtrend. Several of these moves up and down around the moving average can cause a trader to take positions in the wrong direction, or cause more trades to be taken in general increasing transaction costs. False signals that come during trading ranges, or at any time, are called whipsaws. The risk of whipsaws is what causes moving averages to work poorly during trading ranges.