Understanding Moving Averages (Part 4)

04/03/2008 12:00 am EST


20 Days & the Moving Average Cross

There are those who pretend that they understand why the twenty day moving average is such a popular choice of today's traders. The answer may simply be that the average charting software offers this time frame as a default setting, or it may be that minus the weekends this time frame represents about a month of market activity.

Whatever the case may be, an increased number of traders around the world follow this number, and thus theory becomes reality. In other words, why do technical indicators often work as well as they do? Well, market sentiment is everything; remember human beings drive any financial market. If enough human beings believe in the same indicator and the same time frame for that indicator, often there is no better way to go than with the crowd.

Market sentiment when shared by the masses most often becomes market reality. That is why an untrained trader often finds him or her self baffled by a price move that does not make any logical sense. But, perhaps this trader was unaware of the fact that after a large and intense move up in the market technical analysts around the world were all looking at the same Fibonacci retracement levels (material for a later course, no need to fret). As such, everyone believes that the market will retrace at the same Fib levels and so everyone begins to sell at the same level, thus pushing the market down; sentiment becomes reality. For this very reason it is imperative that anyone serious about trading the markets, must first learn the basics of technical analysis. Often technical analysis and market sentiment are one in the same.

The moving average cross is a tool that should not be overlooked. As can be seen in figure 5 below, there are two moving average lines plotted on this chart.

The idea is to combine a short term moving average with a long term moving average. For example, a ten day moving average on top of a twenty day moving average. Of course the shorter moving average period will react more quickly to price direction, whereas a smoother less volatile line will represent the longer moving average period. When the two lines cross, this is considered an indication of a quickly approaching trend reversal or change in price direction. As always, watch for the angle of the moving average line, particularly the shorter time frame (in this case the ten day moving average). When lines cross with a sharp angle and an obvious separation from one another nine times out of ten a trader can count on a change in price direction. Do not trust moving average crosses that are represented by lines on top of one another. The two periods might have crossed, but if there is not a sharp angle and a good degree of separation after the cross expect a sideways market for the time being.

More in part 5 tomorrow.

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