What Are Moving Averages – How Can They Help Us With Trading?
A moving average is an average of the price between one time frame and another, smoothened out over time. By taking the average closing price of a currency pair, over a number of periods, you will be finding out the “moving average”. By a period we mean the time frame of each candlestick.
How To Calculate a Simple Moving Average (SMA)
Let us suppose we are looking at a 1-hour chart. If we are looking at a 10 period simple moving average, all we have to do, is find the closing price of each candlestick, for the last 10 candlesticks. Add the price together and then divide by 10. If we are looking at plotting a 10 period simple moving average on a half hour, chart, we find the closing price of the last 10 candlesticks, add it up and divide by 10. Same principle would be true, if you are looking plotting a 30 period simple moving average. On a 1-hour chart, you pick the closing price of the last 30 candlesticks, add together and then divide by 30. The resulting price is average price.
If you are actually hand plotting the lines, you will find the price average of the previous 30 candlesticks and plot the average price on your chart. By linking the two prices, you get your moving average. Luckily today, all charting stations will give you the option to plot using their tools, so there is no need to calculate anything by hand. But this is the principle in general. If you plot very short time frames like 5 candlestick period, you are going to have a chart which is a lot less smooth than one which is a 30 period time frame.
Watch this video explaining what moving averages are.
Exponential Moving Average (EMA)
As the name indicates for SMA – the price configuration is “Simple” therefore price action can be determined by simple arithmetic. However, SMA’S can give rise to many spikes and zig-zags, which could affect our judgment in the way we use them. For example, if there is a spike due to a news release, than you may be seeing the price movement as a serrated tool. EMA’s or Exponential Moving Averages, give more weighting to the recent periods. The price is loaded heavier to the recent days, than the SMA. As such spikes, which could be very sharp with the SMA’s are now smoothened out by the EMA’S. As such the price represented by the EMA’s are more accurately represented in recent price action. It is a smoother line. EMA’s give more emphasis on the recent turn of events. This is important, because when you are trading, it is much more important to see what is happening NOW rather than just look at the past.
One of the very good value of a simple moving average is finding a trend. In an uptrend you can see that the price action tends to happen above the moving average line plotted on the chart. Alternatively, when the price action is happening below the moving average line plotted on the chart, we are generally speaking looking at a downtrend. This is all fair and square. However the problem with looking at just one time frame, is that it is too simple.
As the name implies, with simple moving averages, they react according to price movements, within their time frame. But they are latent.
Let us imagine a situation, where we are looking and the EUR/USD. The price is generally on a downtrend, however, at noon there is a high impact news, which makes the Euro surge up against the Dollar. This is against the general trend, and is probably very temporary. If you can see how this affects the price of the moving average, you see that the average line is now cutting above the trend line. If you are not aware that there is a news update, you may think that this is an indication of a price change. But in fact, what this is actually is a “fake out”. After a short while, the price settles back to the slippery road of downhill.Getting faked out is not fun. It is easy to get caught in the cross-fire. So how can this problem be avoided, or at least decreased?
One of the best solutions is to plot different time frames. Let us have a look at the same scenario but this time with 10 and 20 SMA’S. Naturally, the shorter time frame is much more reactive than the longer time frames. As such you will find that the 20-period SMA is a much smoother line than the 10-period SMA. Naturally you can add even more slow averages by putting a 30 or 60-period SMA. What has to be borne in mind is that the lines should be placed in order. Ideally use different colours to identify them. The movement is fastest to slowest in an uptrend, and slowest to fastest in a downtrend.
Moving Average Cross Overs – Time to Trade
Moving averages are an excellent tool in fundamental analysis, to help you determine, when you are going to pick a trend change. The Cross-Over between different period SMA’S is a very significant signal. If moving averages cross over one another, it usually means that a trend is about to end, and this could be a perfect chance to take a trade in the opposite direction. Although, this is not a system which is infallible – the “cross-over” of different period SMA’s is a very strong indicator. Use this together with other indicators for price confirmation and you should be making some very positive trades. As with other indicators, the SMA’s work best in a trending or even volatile market. However, they are pretty useless in a ranging market. What will happen in a trending market, is that you will get plenty of cross-overs which do not mean anything much.
Using Moving Averages as Support and Resistance Levels
Moving Averages can act as dynamic support and resistance lines. It is dynamic, because it is not the typical “top” and “bottom” lines that we have learnt to plot for the support and resistance. If we look at the chart below, we can see how the price bounced off the EMA (exponential moving average) on different occasions until the support turned into resistance.
As with standard support and resistance, you will always get a few bars, which can dip into the support and resistance. Sadly there is no such thing as a perfect indicator. Again, using more than one SMA-period will provide a better picture in order to assess strategies.
Conclusion for Using Moving Averages
Moving Averages are a way in which price action can be smoothened out. Although there are different types of moving averages, the Simple and the Exponential are the most commonly used.
Exponential or EMA’s place more weighting to recent price movement.
Simple Moving Averages or SMA’s give a faithful rendition of price movement, but are susceptible to spiking.
Exponential averages can help you spot a trend faster, but it is also prone to fake outs.
- Spot Trends
- Used them as an Indicator when they “Cross Over”
- Used as Dynamic support and resistance levels.
Traders ought to experiment with different time frames and see what results each time frame gives them, in order to determine trading styles.
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