Lesson 23 – Moving Averages, A Guide for Forex Traders
The moving average is one of the most widely used technical indicators in all kinds of markets.
And for good reason.
They are simple to grasp and to give you an excellent summary of the current market tendencies and price history.
They are so useful and so commonly used that the 50 and 200 moving averages in many chart time scales act as powerful supports and resistance zones since so many traders are using them. More on this later.
So what is a Moving Average in Forex Markets?
A moving average is a line on a chart that signifies the average of the closing price of past candles over a specific time period.
You will often notice your charts, especially small timeframe ones showing wild price fluctuations which can make the overall market sentiment hard to read. Moving averages help simplify this by creating a smooth line that sums up the recent price action.
The main use of a moving average is to be able to more easily find trends and spot a reversal as it is happening.
So, when the price of a currency pair is above the moving average, it is considered an uptrend.
Likewise, when the price is below the moving average, it is considered a downtrend.
And when the trend line breaks, more specifically, when the price crosses the moving average, this is considered a trend reversal.
Moving averages are base on past price and are known as a lagging indicator. This means the information you have from them now has already happened.
And furthermore, they cannot predict exactly when or that a trend reversal will happen, they only confirm it once it has happened.
There are a few types of moving average that we can use in our trading strategies. The main two that we will cover in this course are the simple moving average (SMA) and the exponential moving average (EMA).
Let’s go into depth on each one.
The Simple Moving Average (SMA)
Lets assume in an example that you are using the 5 day SMA for your chart. This mean that your moving average line will be a simple mean average closing price of the previous five days.
In this example, we’ll assume the closing prices over the last days were 1.60, 1.71, 1.64, 1.67 and 1.59.
Then, the maths to result in the moving averages line will be like this:
(1.60 + 1.71 + 1.64 + 1.67 + 1.59)/5
So in this case, our moving average would be 1.642
Obviously, the longer the SMA reaches into the past, the less responsive it is to immediate movements in the price action.
As each of the past price points are weighted equally, the most recent price action affects the SMA just as much as the price action 5 days ago in the above example.
This can be problematic for traders as the SMA is rather unresponsive and could fail to react to rapid price movements that could be key to a potential winning trade strategy.
This is why the exponential moving average is used, as it solves this problem.
The Exponential Moving Average (EMA)
The EMA works the same in principle as the SMA, however its crucial difference is that it adds more weight to the more recent data points and removes weight from the data points further in the past.
This makes the EMA much more responsive to recent movements in the markets while similarly fulfilling the information summary the SMA does.
This is beneficial to traders as trend reversals can be found more quickly as the EMA can display this quick change in market sentiment and will switch its angle quickly enough to find a good trade.
Due to this, if you look at your charts with both EMA and SMA visible you will see the EMA is closer to the actual price shown in the candlesticks. And that the EMA is more volatile than the SMA.
When trading, its is much more tactical to consider the information happening now with your techinical indicators rather than further in the past, as all this information has already been digested and traded into by the market.
Lengths of the Moving Averages
The length of the moving average you select for your chart will have a significant difference to the information you will be interpreting. Most traders opt to use many EMAs at the same time to have both a short, medium and long term summary of the price action to identify trends easily.
Here are the most commonly used moving averages:
- 10 EMA, for short term
- 50 EMA, for medium term
- 200 EMA, for long term
How to trade using Moving Averages
Moving averages, especially the mostly used ones being the 50 and the 200, act very similarly to support and resistance lines. As many traders and market participants use them at the same time, the price almost always has a reaction when meeting or crossing the moving average line.
Keep this in mind when setting up your trades or when in a trade.
Look for either a bounce or a breakout at one of these points of crossing and expect further movement to follow that momentum, and enter a trade accordingly.
As a general rule, when the price is under the EMA it will act as a resistance level to break through or bounce off of. And likewise for being over the EMA and a support level.
Because of this, when the price crossed a significant EMA (mostly 50 or 200) it would be considered a signal to trade as we have a price breakout.
Coming Up Next
Next up we will be covering the RSI, Relative Strengthen Index, a very popular tool for us traders which helps us gauge the market sentiment of each forex pairing quickly.
See you there.