What is a moving average?
One of the most essential skills of a forex trader is their ability to predict market trends. By doing so, they have the ability to make critical investment decisions before widespread knowledge of the trend is available and thus stand to gain more. To accomplish this traders utilize technical indicators.
One of the most widely used technical indicators for forex traders is the moving average. As the name indicates, a moving average basically involves an arithmetic mean of how a traded commodity has been performing over a period of days. This helps the trader to look beyond the normal day-to-day fluctuations and at the bigger picture.
A moving average, as stated before, is calculated from the currency’s performance over a predetermined period of days. For example, here is a 5-day moving average:
(5+7+9+12+9)/5
Here you can see that the closing prices for each day are added together at the top and then divided by the number of days to give a moving average of $8.4.
Similarly for the next period, the first number would be dropped to be replaced by a new value at the end. This give another 5-day moving average of $9.6, thus depicting an upward trend from the previous value:
(5+7+9+12+9+11)/5
As you can guess, the above phenomenon is the reason for the word moving in the name of the moving average. It is dynamic. It changes with time.
An important point about moving averages is that they are not essentially predictors about how a market would react. They just make the trends clearer once they have been established and leave the predicting to your experience. This is why they are called lagging indicators, because they are reliant on past data to give a trend line (moving average line) about how a currency has behaved.
The most common moving averages involve time periods of 15, 20, 50, 100 and 200 days. The difference lies in how they are represented on a Forex graph. A lengthy time period moving average line, like that based on 200-day periods would be smoothed out and won’t correspond with the Forex graph that much. A 20-day moving average line, on the other hand, would be much more jagged and would tend to hug the Forex graph. There is no right or wrong between which moving average you chose. It is all dependent upon personal preferences.
What is a simple moving average?
In much of the last section, we have focused on a type of moving average that is known in technical circles as the simple moving average (SMA). As you have seen before, it involves simple arithmetic and isn’t complex because it gives equal weight to all values.
What is an exponential moving average?
An exponential moving average (EMA) is the complicated cousin of SMA. It was designed by the critics of SMA who argued that recent price data is more significant than older one and thus should have more weight attached to it. Thus the EMA involves a weighed approach when calculating the moving average where the most recent data is deemed more important. EMA is calculated using the following formula:
Sounds complex? No need to worry as you are not required to memorize it. It has just been listed here for illustrative purposes. Most charting software have the formula built into them so you just have to provide the data!
SMA vs. EMA
So, now the question arises? What are the differences between the two aforementioned moving average techniques?
- SMA, as discussed before, gives equal weight to all the currency values. It doesn’t matter to SMA whether a value is 199 days old or is that of yesterday, it just adds them up with all the other data and then divides it with the defined time period. EMA, on the other hand, is more intelligent in the way it deals with data provided to it. It gives more weight to recent data than the old one because the recent data is more indicative of how the market is going to perform in the future.
- These variations in calculation technique results in marked differences between how a moving average line corresponds to a Forex chart. For the same time periods, an SMA line would be slower to react to market changes than an EMA one. As a result EMA finds widespread use by traders while SMA is more popular with technical analysts.
Despite the differences, no moving average technique is superior to the other. And neither of them guarantees sure-shot success. Which moving average you use in your analysis is a matter of your personal opinion.
How to use moving average to trade the market?
Hopefully, now you will have a sound grasp on what a moving average is. Therefore now comes the application part. How will you interpret a moving average line and employ it to trade currency?
The most common type of technique employed to do so is known as the crossover. A crossover occurs in one of the following two ways:
- When the Forex graph cuts across a moving average line.
- When a short term moving average line cuts above a long term moving average line and vice versa.
In the first instance, if the Forex graph cuts below a moving average line then this would signal a potential downtrend. Similarly, if the Forex graph cuts above a moving average line, it would indicate that there would be a potential rise in the prices.
In the second situation, a buy or sell signal is generated depending upon the scenario. If, say, a 15-day MA line goes above a 100-day MA line then a buy signal is generated in the wake of potential increase in prices. In continuation, when, say, a 200-day MA line goes above a 20-day MA line, a sell signal is created because the prices are more than likely to go down.
In conclusion, moving averages are one of the many indicators employed by traders in the Forex market. It is pertinent to mention that they do not guarantee success on their own but are rather tools in your repertoire that you can use to attain good returns.