“The trend is your friend!” “Never bet against the trend!” “Trying to anticipate a change of direction in the trend is like trying to catch a falling knife….sometimes you catch the handle, but most times you get cut.”
These are all market sentiments codified into easy to remember axioms to help all traders remember that the equity will tend to move in the direction of its trend…until it doesn’t.
Perhaps the simplest of all ways to determine a trend by using a moving average. A moving average simply takes the closing prices from a specific number (N) of recent periods, adds them all up and divides them by N to plot a point. For every passing period, the oldest is removed and the newest is added, the average is determined and another point is plotted. This happens over and over again on your chart.
Moving averages slow down price action and make it easier to spot the trend. The idea is to find a moving average that seems to work with both with the equity pair you’ve chosen to trade and the time frame you’ve chosen to work in.
Determining the length of the moving average (more periods or fewer periods) should be done both by common sense (looking at how it follows price action on the chart) and also through backtesting.
See below for a 15-minute chart of the EUR/USD currency pair with a 4 period EMA. Looking at this chart, ask yourself, would this indicator help you spot the trend?
Now here is the exact same chart but showing a 10 period EMA instead of a 4 EMA. See a difference? Would this chart be more helpful to you in your trading?
Make your moving average period too small and it simply follows the price action providing little help in determining the trend. Make it too large and the equity moves too much before you have your opportunity to get in.
The goal with any moving average is to get you in closer to the bottoms of the change in direction and out closer to the tops of the change in direction, maximizing your trade’s value.
The moving average you choose becomes your baseline indicator and sets your expectation of being bullish or bearish (whether you go long or short). When using this strategy, for example, you wouldn’t short a pair in a bullish trend. Remember, the trend is your friend!
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