A
moving average is simply a way to smooth out price action over time. By
“moving average”, we mean that you are taking the average closing price of a
currency for the last ‘X’ number of periods.
Like
every indicator, a moving average indicator is used to help us forecast future
prices. By looking at the slope of the moving average, you can make
general predictions as to where the price will go.
As we
said, moving averages smooth out price action. There are different types of
moving averages, and each of them has their own level of “smoothness”.
Generally, the smoother the moving average, the slower it is to react to the
price movement. The choppier the moving average, the quicker it is to
react to the price movement.
We’ll explain the pros and cons of each type
a little later, but for now let’s look at the different types of moving
averages and how they are calculated. Leading vs. Lagging Indicators
We’ve
covered a lot of tools that can help you analyze charts and identify trends. In
fact, you may now have too much information to use effectively.
In this
lesson, we’re going to look at streamlining your use of these chart indicators.
We want you to fully understand the strengths and weaknesses of each tool, so
you’ll be able to determine which ones work for you and your trading plan…and
which ones don’t.
Leading versus Lagging Indicators
Let’s
discuss some concepts first. There are two types of indicators: leading
and lagging.
A
leading indicator gives a buy signal before the new trend or
reversal occurs.
A
lagging indicator gives a signal after the trend has started and basically
informs you “hey buddy, pay attention, the trend has started, you’re missing
the boat.”
You’re
probably thinking, “Ooooh, I’m going to get rich with leading indicators!”
since you would be able to profit from a new trend right at the start. You’re
right – you would “catch” the entire trend every single time, IF the leading
indicator was correct every single time. But it’s not.
When
you use leading indicators, you will experience a lot of fake-outs. Leading
indicators are notorious for giving bogus signals which will “mislead” you.
Get it? Leading indicators that "mislead" you? Ha-ha. Man we're
so funny we even crack ourselves up.
The
other option is to use lagging indicators, which aren’t as prone to bogus
signals. Lagging indicators only give signals after the price change is clearly
forming a trend. The downside is that you’d be a little late in entering a
position. Often the biggest gains of a trend occur in the first few bars, so by
using a lagging indicator you could potentially miss out on much of the profit.
Which sucks.