For currency forex traders, the use of moving averages is common. For many, moving averages are commonly used as an indicator in part of a trading system.
As we make use of historical data to compute moving averages, they invariably contain a lagging effect.
Hence, with the use of moving averages in forex trading which is fast paced, the question which arises is this: “How effective are moving averages (which forms a lagging indicator) within a technical trading system for forex trading which is fast paced?”
A question as controversial as this would lead to much differences of opinion, each centering on how lagging moving averages are.
Rather than putting emphasis on these differences of opinion, a better solution is to accept that moving averages do play a role in technical analysis and charting, and to consider ways to reduce the lagging effect.
I have, for instance, seen forex traders who trade with nothing else except moving average lines, and yet among them are many profitable traders.
Do they use the standard moving average lines, or rather, how do they use the moving average lines?
In trying to overcome the lagging effect of moving averages, one simple way is to adopt exponential moving average in lieu of the standard moving average line as an indicator. Others , adopt the weighted moving averages, where more weight is given to newer price data.
A brillant solution is to adopt a mathematical approach towards the lagging effect by computing the moving averages as adaptive moving averages. In this particular case, the moving averages are allowed to self adjust to the prices based on a special adaptive computation and thus represents a clearer and truer of current price.
As part of the computation, it is possible to project the adaptive moving average forward by a certain number of bars or days where the moving average would have lagged the market, thus compensating for the lagging effect and even neutralising the lagging effect.
In all these trading systems involving the use of moving averages, applied in conjunction as 3, 4 or even 5 exponential moving averages together as a band to form a rainbow, or as a single adaptive moving average, it is to the best interest of the forex trader to back test the trading systems and to test out the profitability of the trading system using a forex strategy builder or a trade simulator. Then it is possible to know whether the use of these modified moving averages will enhance the robustness of a trading system or otherwise.
One note of caution is in order. In using moving averages, it is dangerous to optimize the moving averages to fit in with the best profitability, as over-optimization will lead to a non-representative trading system. You can get very good trading results and the best profitability from over optimization of the moving averages, but such a trading system involving the over-optimized moving averages is bound to fail, and will lead to disastrous results.
As moving averages are representation of price itself, the next question is – why not use price itself as an indicator rather than a representation of price which induces lag?
Indeed there are many forex traders who avoid the use of moving averages because of their inherent lag. To be able to monitor price itself, they would use price levels, favoring fibonacci levels, price pivots, gann levels and Murrey Maths levels. This has led to the use of a price time action method and a dynamic analysis based on time and price.
So if you are using moving averages in your trading system, be aware of the lagging effect. Check out whether a price time action method can be useful to you if the lagging effect is a concern of priority to you.