We all know about the importance of horizontal levels of support and resistance … and why we draw on trend lines.
So why and how would moving averages help us here? Moving average is just an average of closing prices over recent days – what logic tells us that it will have a magical effect on price turning points?
One look at these charts will convince you that these are worth paying attention to, and when you understand why and how they work, these dynamic support and resistance levels can have a powerful impact on your profits.
Notice how I said ‘dynamic’?
That is because this blog isn’t about Support and Resistance.
It is about DYNAMIC Support and Resistance.
So what’s the difference?
We know about support and resistance as horizontal lines or diagonal trend lines, but dynamic support and resistance is different.
The main difference being the support and resistance levels, as they are nothing like the traditional horizontal lines.
Dynamic support and resistance levels are constantly changing and moving with the price.
Forex traders will buy when price dips and tests the moving average or sell if price rises and touches the moving average.
But before we go any further, it is important to note that dynamic support and resistance is not nearly as strong or indicative as horizontal and diagonal support and resistance.
We don’t recommend ever using moving averages all by their lonesome self to define levels of support and resistance. Having said that, they do have their uses.
Here we have a daily EUR/USD chart and we’ve popped on the 10 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 10 EMA and tested it, it acted as resistance and price bounced back down.
Pretty amazing, huh?
However, there was a point in mid-September where the price broke quite significantly above the line. This turned out to be a fakeout as the downtrend continued towards the end of the month and into October.
One thing to keep in mind is that price will not always bounce off the moving average. Sometimes it goes a little more before returning to the direction of the main trend, and sometimes the price breaks such resistance altogether.
What some Forex traders do is that they add more than one moving average to a chart, and only buy or sell once price is in the middle of the space between the two moving averages.
This area is called ‘the zone’.
Let’s take another look at the daily EUR/USD chart, but this time let’s use 50 EMA on top of the 10 EMA.
Once we include the 50 EMA as well, we can see that – although the 10 EMA level was broken – the 50 EMA level held during that brief rally in September.
Adding the 50 EMA also throws up a strong crossover signal at the end of a period of consolidation in November and early December, just before the market goes into an uptrend.
The idea is that just like the classic horizontal support and resistance areas, these moving averages should be treated like zones or areas of interest.
The area between moving averages could be considered as a zone of support or resistance.
Why Does Dynamic Support and Resistance Work?
The reason that moving averages are so powerful as support and resistance levels are very similar to the reasons why price action works.
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.
90% of traders who use moving averages use one 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 uses one of these AND has come to expect it to act as dynamic support or resistance?
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 you can use.
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.
Speaking of adding tools to your toolbox…. See you in Level 7?
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