Moving Average

Learn to trade Moving Average

A moving average is simply a way to smooth out price action over time. By “moving average”, I mean that you are taking the average closing price of a currency for the last ‘X’ number of periods.

Like every indicator, it is used to help us forecast future prices. By looking at the slope of the moving average you can make general predictions as to where the price will go.

As I said, moving averages smooth out price action. There are different types of moving averages, and each of them have their 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.

Simple Moving Average (SMA)
A simple moving average 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. If you plotted a 5 period simple moving average on a 1 hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5.

If you were to plot a 5 period simple moving average on a 10 minute chart, you would add up the closing prices of the last 50 minutes and then divide that number by 5.

If you were to plot a 5 period simple moving average on a 30 minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.

If you were to plot the 5 period simple moving average on the a 4 hr. chart

Most charting packages will do all the calculations for you. The reason I just bored you (yawn!) with how to calculate a simple moving average is because it is important that you understand how the moving averages are calculated. If you understand how each moving average is calculated, you can make your own decision as to which type is better for you.

Just like any indicator out there, moving averages operate with a delay. Because you are taking the averages of the price, you are really only seeing a “forecast” of the future price and not a concrete view of the future.

Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated with it. Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean:

Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows:

Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370

The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358

Simple enough right? Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).

The point I’m trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way! It’s called the Exponential Moving Average!

Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.