Moving averages are one most commonly used technical indicators.
A moving average is simply a way to smooth out price fluctuations to help traders distinguish between typical market “noise” and the actual trend direction.
By “moving average”, it means that traders taking average closing price of a currency pair for the last ‘X’ number of periods.
On a chart, it would look like this:
the moving average looks like a squiggly line overlayed on top of the price (represented by Japanese candlesticks).
This type of technical indicator is called a “chart overlay“.
Like every technical indicator, a moving average (MA) indicator is used to help forecast future prices.
The reason for using a moving average instead of just looking at the price is due to the fact in the real world, trends do not move in straight lines. Price zigs and zags so a moving average helps smooth out the random price movements and help to “see” the underlying trend. By looking at the slope of the moving average, trader can better determine the trend direction.
There are different types of moving averages and each of them has its own level of “smoothness”.
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it is to react to the price movement.
To make a moving average smoother, trader should get the average closing prices over a longer time period.
How to Choose the Proper “Length” of a Moving Average
The “length” or the number of reporting periods including the moving average calculation affects how the moving average is displayed on a price chart.
The shorter its “length”, the fewer the data points that are included in the moving average calculation, which means the closer the moving average stays to the current price.
This reduces its usefulness and may offer less insight into the overall trend than the current price itself. The longer its length, the more data points that are included in the moving average calculation, which means the less any single price can affect the overall average.
If there are too many data points, price fluctuations may become “too smooth” that trader won’t be able to detect any kind of trend!
Either situation can make it difficult to recognize if price direction may change in the near future.
For this reason, it’s important to select the length (or periods) that provides the level of price detail appropriate for trader’s trading timeframe.
There are two major types of moving averages:
Remember, Moving average do NOT predict price direction; instead, they define the current direction with a lag.
Simple Moving Average (SMA) Explained
A simple moving average (SMA) is the simplest type of moving average.
Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X.
However, as with almost any other forex indicator out there, moving averages operate with a delay. Because only the averages of past price history were taken, traders are really only seeing the general path of the recent past and the general direction of “future” short-term price action.
The longer period used for the SMA, the slower it is to react to the price movement, because longer SMA has longer period. With the use of SMAs, it tells whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average: they are susceptible to spikes. When this happens, this can give us false signals.
Exponential Moving Average (EMA) Explained
Exponential moving averages (EMA) give more weight to the most recent periods. The EMA would put more weight on the prices of the most recent days, as a result, the spike day would be lesser value and wouldn’t have as big as effect on the moving average.
Exponential Moving Average (EMA) vs. Simple Moving Average (SMA)
The exponential moving average places more emphasis on what has been happening lately than simple moving average. EMA would be the best way to do if trader try to indicate the price action rather quickly. These can help to catch trends very early, which will result in higher profit. In fact, the earlier traders catch a trend, the longer traders can ride it and rake in those profits.
With a simple moving average
The simple moving average would be the best way to do if trader want a smoother and slower to respond to price action. This would provide a overall trend. Although it is slow to respond to the price action, it could possibly save traders from many fake outs. The downside is that it might delay traders too long, and traders might miss out on a good entry price or the trade altogether.
When to Use SMA vs. EMA
With moving averages in general, the longer the time period, the slower it is to react to price movement.
But with all else being equal, an EMA will track price more closely than an SMA.
Because of this, the exponential moving average is typically considered more appropriate for short-term trading.
The same attributes that make the EMA more suited for short-term trading limit its effectiveness when it comes to longer-term trading.
Since the EMA will move with price sooner than the SMA, it often gets whipsawed, making it less than ideal for triggering entries and exits on “slower” chart timeframes like daily (or longer).
The SMA, with its slower lag, tends to smooth price action over time, making it a good trend indicator, allowing it to remain long when the price is above the SMA and short when the price is below the SMA.
Many traders plot several different moving averages to give them both sides of the story.
They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.