Forex Walkthrough

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Level 4 Charts - Moving Averages

Among the most widely used technical indicators, a moving average is simply a tool traders use to smooth out the price movement in a given currency. Price movements can be volatile in the short term, so many traders will use a moving average in order to identify or gauge the direction of a trend.



Mathematically, moving averages are calculated by taking the average price of the currency over a certain number of days or periods. For example, a 50-day moving average would be calculated by adding up all the prices the currency closed at over the previous 50 days and then dividing by 50. All modern day charts will usually automatically do this for you. Once determined, the resulting moving average is then overlaid onto the price chart in order to allow traders to look at smoothed data rather than focusing on the day-to-day price fluctuations. An example of a 50-day moving average is shown in Figure 1. (To learn more about the construction of a moving average, take a look at Simple Moving Averages Make Trends Stand Out.)





Figure 1


Because of the way moving averages are calculated, you can customize your moving average to literally any time period you think is relevant, which means that the user can freely choose whatever time frame they want when creating the average. The most common increments used in moving averages are 15, 20, 30, 50, 100 and 200 periods. Shorter moving averages such as the 15 period, or even the 50 period, will more closely mirror the price action of the actual chart than a longer time period moving average. The longer the time period, the less sensitive, or more smoothed out, the average will be. There is no "right" time frame to use when setting up your moving averages.

Often in Forex, traders will look at intraday moving averages. For example, if you're looking at a 10 minute chart and wanted a five-period moving average you could take the prices in the previous 50 minutes and divide by five to get the five-period moving average for a 10 minute chart. Many traders have their own personal preference, but usually the best way to figure out which one works best for you is to experiment with a number of different time periods until you find one that fits your strategy.



SMA vs. EMA
There are actually two general types of moving averages: the simple moving average (SMA) and the exponential moving average (EMA). The moving average we were discussing previously is a simple moving average because it simply takes a certain number of periods and averages it for the desired time frame - each period is equally weighted. One of the main complaints with a simple moving average (especially short-term ones) is that they are too susceptible to large price movements up or down. For example, suppose you were plotting a five-day moving average of the USD/CAD and the price was steadily and consistently going up. And then one day there was a large down spike anomaly causing the moving average to go much lower and the trend to go down when perhaps that one day could have been caused by something not likely to occur again.

To mitigate this problem you may want to use a different moving average - an exponential moving average (EMA). An EMA gives more weight to the more recent prices in its calculation of a moving average. So if you were using a five-day moving average, an EMA would give a higher weight to prices occurring at the end of the five day period, and lower weight on prices occurring five days ago. So if a large spike occurred on days one or two, the moving average wouldn't be affected as much as a simple moving average. Again, traders should experiment with both types of moving averages to find their preference. In fact, many traders will plot both types of moving averages with various time periods at the same time. (Learn more about the EMA in our article Exploring The Exponentially Weighted Moving Average.)

One of the primary uses of a moving average is to identify a trend. In general, moving averages tend to be lagging indicators meaning they can only confirm that a trend has been established rather than identifying new trends. In the next section we'll take a closer look at how moving averages are used to gauge the overall trend of a currency.

Trends
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