Forex Walkthrough

AAA

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
Related Articles
  1. Forex Education

    5 Foreign Currencies Americans Buy the Most

    Look at which currencies Americans buy the most for travel abroad and remittances, and how the current strength of the dollar is impacting those transactions.
  2. Trading Strategies

    Short Interest: What It Tells Us

    A stock’s short interest is the total number of shares that investors have sold short but have yet to close.
  3. Trading Strategies

    Mastering Short-Term Trading

    The proper application of a few different tools can help a short-term trader succeed.
  4. Investing Basics

    How You Make Money In Real Estate

    No matter what anyone tells you, the basic ways that money is made through real estate haven’t changed in centuries.
  5. Investing Basics

    Free Cash Flow Yield: A Fundamental Indicator

    Free cash flow can measure a business’s performance as if you’re looking at its net income line.
  6. Technical Indicators

    Four Commonly Used Indicators In Trend Trading

    No single indicator can punch a ticket to market riches, but here are four that remain popular among trend traders.
  7. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  8. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  9. Your Practice

    What the Next Decade Holds for Financial Advisors

    A look at the top trends of the financial advisory business in the next decade.
  10. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
RELATED TERMS
  1. Collateralized Mortgage Obligation ...

    A type of mortgage-backed security in which principal repayments ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Golden Cross

    A crossover involving a security's short-term moving average ...
  5. Cup and Handle

    A pattern on bar charts resembling a cup with a handle. The cup ...
  6. Percentage Change

    Percentage change is a simple mathematical concept that represents ...
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  4. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center