We all know about the importance of horizontal levels of support and resistance. And, we also understand why we draw trend lines. If you’re not clear on how these two concepts apply to price action, be sure to review our previous lessons!
So, why would moving averages help us here? After all, a moving average is just an average of closing prices over recent periods – what logic says it will have a magical impact on price turning points? Well, moving averages are powerful indicators. They can serve as both key support and resistance levels.
One look at Japanese candlestick or OHLC bar charts will convince you that dynamic support and resistance levels are worth paying attention to. Upon gaining an understanding of how and why they work, these types of technicals can have a powerful impact on price action and your profits.
Notice how I said ‘dynamic’? That’s because this blog isn’t about conventional support and resistance levels. It’s about DYNAMIC support and resistance. There’s a big difference between the two and how they are applied to evolving price action.
Let’s dive into this exciting concept and check out a few of its applications to the financial markets.
We know about support and resistance as horizontal lines or diagonal trend lines, but the idea of dynamic support and resistance is different. In fact, it’s a discipline all its own!
The main difference between dynamic support and resistance and standard support and resistance levels is that they are constantly changing with price action. Basically, as price moves, so do dynamic support and resistance levels. This is especially applicable to products that are consistently volatile and active.
In practice, dynamic support and resistance is applied to assets in the stock market, futures market, and the forex. The concept can be a powerful tool for identifying entry points as well as exit points. Take it from us, both dynamic support and dynamic resistance are invaluable for placing seemingly chaotic price action into context.
For instance, forex traders frequently use a moving average as a market entry point. Although one of the simplest trading strategies, currency traders will buy a specific pair when the price dips and tests the moving average. Conversely, they’ll sell if the price rises and touches the moving average. Although this isn’t an iron-clad trading strategy, it isn’t a bad way of entering the market with consistency!
However, before we go any further, it’s important to add a caveat: dynamic support and resistance is not nearly as strong or indicative as horizontal and diagonal support and resistance. Even though it’s a reputable indicator, a solid horizontal support or resistance area can be a much better bullish or bearish trading signal.
From a functional standpoint, we don’t recommend ever using moving averages all by their lonesome to define levels of support and resistance. It’s typically always better to confirm tendencies in price action with at least one other indicator.
Having said that, dynamic support and resistance levels do have their uses.
One of the great things about being a modern trader is that our software trading platforms make technical analysis a breeze. All we have to do is select our indicator, define the parameters, and viola – instant analysis!
Dynamic levels are no different; select an indicator, define its inputs and apply it to price action. Here we have a daily forex market EUR/USD chart and we’ve popped on the 10-period exponential moving average (EMA). Let’s see if it serves as dynamic support or resistance.
As you can see, the 10 EMA resistance level held really well for most of the downtrend. Almost every time price approached the 10 EMA and tested it, it acted as resistance and the price bounced back down. Pretty amazing, huh?
Of course, no indicator is infallible, not even the exponential moving average. There was a point in mid-September when the price broke quite significantly above the line. This was a fairly large fake-out as the downtrend continued towards the end of the month and into October. In this instance, the 10 EMA failed as horizontal support and resumed its role as a dynamic resistance.
As a general market commentary, the price will not always immediately bounce off a moving average that is set up as dynamic support or dynamic resistance. Sometimes it will go a little more before returning to the direction of the main trend. In other cases, the price smashes through such levels altogether.
Some Forex traders add more than one moving average to a chart and only buy or sell once prices are in the middle of the space between the two moving averages. This area is called ‘the zone’. As always, this strategy is only one way to skin a cat and does not constitute investment advice.
Let’s take another look at the daily EUR/USD chart. This time, however, let’s combine the 50 EMA with the 10 EMA to gain a multi-indicator view of the market.
Once we include the 50 EMA, we can see one key point: although the 10 EMA level was broken, the 50 EMA level held firm during that brief rally in September. This confirms the direction of the prevailing trend.
Adding the 50 EMA also throws up a strong crossover signal at the end of a period of consolidation in November and early December. This signal turned out to be a precursor for a bullish rally, occurring just before the market entered an uptrend.
The idea is that just like the classic horizontal support and resistance areas, these moving averages should be treated as zones or areas of interest. In fact, the area between moving averages could be considered a zone of support or resistance all by itself.
The reason that moving averages are so powerful as support and resistance levels are similar to the drivers of price action theory. Ultimately, it all comes down to peer pressure and the fact that thousands and thousands of traders use moving averages.
And, out of all the moving averages that traders use, there’s only a handful of common ones. The result is a feedback loop when the indicators themselves gain relevance. Why? Because they are favored by legions of dedicated traders!
90% of traders who use moving averages use one or more of these five periods:
So what happens when 90% of traders who use moving averages use one of these five?
Well nothing, really…
But what happens when 90% of those using moving averages use one of these AND have come to expect it to act as dynamic support or resistance?
I think you know the answer…
Price will generally respect these moving averages in some way, right? It’s self-fulfilling, or rather group-fulfilling.
If enough people are watching something, and all expect a general outcome, it’s more likely to happen. This is because many traders (unsuspecting or not) use the moving averages listed above as the end-all-be-all; they don’t wait for confluence in order to buy or sell.
But, just like anything else in Forex, there are no guarantees. These moving averages are just another individual tool that you can use.
Remember, you can’t build a house (or in our case, a consistent track record) with just one or two tools – you need the whole toolbox. That’s why it’s imperative that your trading strategies are armed with a collection of powerful analytics, both fundamental and technical.
Speaking of adding tools to your toolbox…. See you at the next level?
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