Understanding Moving Averages (Part 2)

04/01/2008 12:00 am EST

Focus:

Before examining the various calculations and types of moving averages it is essential that we as traders understand what a moving average is trying to tell us. Its message is really quite simple, and is primarily focused on market expectations. A moving average calculating the last 30 days of prices in the market essentially represents a consensus of price expectations over that 30-day period.

Understanding a moving average is at times as simple as comparing the market's current price expectations to that of the market's average price expectations over the time frame that you are viewing. The average gives us a bit of a safe zone, or a range that traders globally are comfortable trading within.

When prices stray from this safe zone, or from the moving average line, a trader should begin to consider potential entry points into the market. For example, a price that has risen above the moving average line typically implies a market that is becoming more bullish, traders are on the up, and with such will come good opportunities to buy.


Just the opposite, when prices begin to fall below moving average lines, the market is becoming visibly bearish; traders should thus be looking for opportunities to sell.

Notice the angle of the moving average shown above at various points across the chart. Moving averages not only give traders a much smoother look at the true trend of the market, they also offer keen directional insight found in the angle of the moving average line. Erratic sideways markets tend to be represented by moving average lines that are flat or sideways, whereas markets that are beginning to trend strongly in one direction or another will begin that trend with a very angled moving average line.

More in part 3 tomorrow.

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