Moving Averages

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.

I’ll explain the pros and cons of each type a little later, but for now let’s look at the different types of moving averages and how they are calculated.


Simple Moving Average (SMA)
A simple moving average is the simplest type of moving average (DUH!). Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X. Confused??? Allow me to clarify. 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. Voila! You have your simple moving average.

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………………..OK OK, I think you get the picture! Let’s move on.

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. Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!

Here is an example of how moving averages smooth out the price action. On the chart above, you can see 3 different SMAs. As you can see, the longer the SMA period is, the more it lags behind the price. Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMA. This is because with the 62 SMA, you are adding up the closing prices of the last 62 periods and dividing it by 62. The higher the number period you use, the slower it is to react to the price movement.

The SMAs in this chart show you the overall sentiment of the market at this point in time. Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now make a general prediction of its future price.


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.

When trading, it is far more important to see what traders are doing now rather than what they did last week or last month.


Which is better: Simple or Exponential?
First, let’s start with an exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. These can help you catch trends very early, which will result in higher profit.

In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits! The downside to the choppy moving average is that you might get faked out. Because the moving average responds so quickly to the price, you might think a trend is forming when in actuality; it could just be a price spike.

With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.

Although it is slow to respond to the price action, it will save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good trade.

So which one is better? It’s really up to you to decide. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.

In fact, many trading systems are built around what is called “Moving Average Crossovers”. Later in this course, we will give you an example of how you can use moving averages as part of your trading system.

Time for recess! Go find a chart and start playing with some moving averages. Try out different types and look at different periods. In time, you will find out which moving averages work best for you. Class dismissed!


Summary:

• A moving average is a way to smooth out price action.
• There are many types of moving averages. The 2 most common types are: Simple Moving Average and Exponential Moving Average
• Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
• Exponential moving averages put more weight to recent prices and therefore show us what traders are doing now.
• It is much more important to know what traders are doing now, than what they did last week or last month.
• Simple moving averages are smoother than Exponential moving averages.
• Longer period moving averages are smoother than shorter period moving averages.
• Choppy moving averages are quicker to respond to price action and can catch trends early. However, because of their quick reaction, they are susceptible to spikes and can fake you out.
• Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
• The best way to use moving averages is to plot different types on a chart so that you can see both long term movement and short term movement.

“The only limits to the possibilities in your life tomorrow are the buts you use today.”

Les Brown