Using The Moving Average As A Contrarian Signal

Moving averages remain one of the most popular methods of trading the forex market, with many traders using them for entering and exiting trades whilst others use them as a simple way to determine what the current trend is.

Today I’m going to show you a way of using moving averages which you’ve probably never come across before.

Most traders who use moving averages as a method of entering trades consistently lose money in the markets, we’re going to use this fact to give us an indication as to when the current trend or movement is likely to stall or end.

I way I know most traders using moving averages lose money is because of the data all indicators are created off.

All trading indicators are created using past price data, this means indicators will lag behind the current price action in the markets. For a moving average to cross the market must have already moved significantly in one direction, for us price action traders it would have been obvious to us that the market has already changed direction, but to the moving average traders their still under the impression the market has yet to change direction until they see the averages cross, so by the time they enter their trades the market is already nearing the end of its current movement.

For a trader to enter a trade based on a moving average he needs to see the slow-moving average cross the fast-moving average, assuming you’re using a 5 day and a 20 day moving average system your entry will happen when the 5 day average line crosses the 20 day average line.

What the traders using moving average don’t know is, I know when they are going to enter their trades. In a market where one traders loss equates to another traders gain this is a serious advantage, if the averages cross it tells me that a lot of traders have just entered the market, most of which are probably going to lose money, using this fact I determine

image of moving averages crossing

In the image above I’ve placed a 5 day and 20 day moving average on the 1 hour chart of EUR/USD

The X’s on the image are placed above the candlestick which made the 5 day average cross the 20 day average.

It’s easy to see soon after the averages cross the market either stalls or pulls back, as with anything in trading this happens for a very specific reason.

If you’ve read my article on “why breakout traders lose money” you’ll know that when a breakout happens the market tends to stall/consolidate or pull back to the point where the breakout occurred, this happens to make all the breakout traders lose money, this is very similar to what happens when the moving averages cross.

When the averages cross all the traders using moving averages will place trades, which means a large amount of buy or sell orders will come into the market, with all these orders coming into the market the institutional traders are suddenly able to take one of two actions.

Note:

Not all traders use a 5 day and 20 day moving average cross nor do they all use a simple moving average, some may use an exponential average for example. It doesn’t matter though because all moving averages lag behind the current price action, no matter what period they’re using in they’re moving average settings or what type of average they’re using, they’ll always be late in reacting to the current changes in the market.

 

The institutional traders can now either take some profits of their existing trades or, place trades in the opposite direction to the orders that have come into the market from the moving average traders.

Most of the time they’ll end up taking profits, which will stop the market from continuing to move higher or lower.

This profit taking will eventually consume all the orders that have come into the market from the moving average traders entering their trades. At this point the market will begin to fall or rise depending on the trend, which will cause the moving average traders to start closing their trades as they are now either at a loss or a profit much smaller than what they had when they first entered their trades.

 

image of moving average traders losing money

The arrow I’ve placed above the candlestick on the image is the point where the moving average traders will have entered their trades, you can see not long after the averages cross the market begins to fall back to this point ( marked with a green rectangle ) and then starts to move higher, the reason it moves higher is down to the moving average traders closing their trades at a loss which would have put sell orders into the market that the institutions would have used to place more buy trades in the direction of the trend.

Aviary Photo_130965672784100776

This is a similar example.

To begin with the market was in a small uptrend, then we get move lower which causes the moving averages to cross over which means we know a lot of traders have just entered into sell trades. A small move down then follows, giving the moving average traders the impression of begin in a good trade, however. This doesn’t last long and a short time later the market pulls back, right to the candle which caused the moving averages to cross, at this point most of if not all the moving average trader will close their trades due them either being scared of potentially losing money or coming out of what was a successful trade with no profit.

The institutional traders use the buy orders generated by the moving average traders closing their sell trades to take more profits off the buy trades they have placed at the beginning of the uptrend.

 

Summary

Succeeding in trading requires you to adopt a contrarian mindset, you’ve got to do things differently to how everyone else is doing them. Most traders don’t do this, they use the same systems with the same rules that everyone else uses, then they wonder why they can’t make consistent money.

The only way for you to start making money trading forex is if you start doing things differently, start studying how other traders trade, what makes them enter and exit trades, where do they put their stop-loss ? All of these things will help you understand the market better and will give you the best possible chance of making consistent profits from the market.

If you start doing this you can come up with trading strategies which very few people have any knowledge of, I’ve never seen another person use moving averages in the way I’ve shown you in this article, the way came up with this was by learning how other people trade, if I didn’t know how moving average traders trade then this method would have never existed.

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