Moving averages are one of the oldest and most commonly used technical indicators. They "smooth out" fluctuations to help you distinguish between typical market fluctuations and actual rate reversals.
MOVING AVERAGES: AN ADVANCED UNDERSTANDING
Moving Averages (MAs) help to filter out market noise and smooth out fluctuations in price. MAs lag - because they are based on past prices - and so they will not predict future price directions. But they are still a key technical indicator in helping distinguish between typical fluctuations and actual price reversals.
IDENTIFYING TREND MOMENTUM
Technical market practitioners have long known that the ability to identify a trend is a key factor in successful trading, which is where MAs come into their own. In order to identify and analyze a price trend, we need to assess both the highs and the lows in price action. Every type of MA is a mathematical outcome arrived at by plotting and averaging data points.
The three most common are the simple moving average, weighted moving average and exponential moving average.
3-TYPES OF MOVING AVERAGES
SIMPLE MOVING AVERAGE (SMA)
WEIGHTED MOVING AVERAGE (WMA)
EXPONENTIAL MOVING AVERAGE (EMA)
A simple moving average is the most basic type of moving average. It is calculated by taking a series of prices (or reporting periods), adding these together and then dividing the total by the number of data points. This formula determines the average of the prices and is calculated in a manner to adjust (or "move") in response to the most recent data used to calculate the average.
EXAMPLE: If the most recent 5 exchange rates are 1, 2, 3, 4 and 5, the average would be the sum of the rates (1+2+3+4+5) divided by the number of reporting periods. 15/5 = 3
Each time a new price becomes available, the average "moves" so that the average is always based only on the last same number of variables. In this case, if the next number in the sequence were 6, the oldest rate (1) would be dropped and the new average would (2+3+4+5+6)/5 which equals 4.
If your main objective is to reduce the noise of consistently fluctuating prices in order to determine an overall market direction, then a simple moving average of the last 20 or so rates may provide a helpful level of detail. This indicator may be slow to react to latest rates. Buy and sell signals may lag even further behind the market.
A weighted moving average places (WMA) puts greater importance on recent data than the EMA by assigning values that are linearly weighted to ensure that the most recent rates have a greater impact on the average than older periods. This means that the oldest rate included in the calculation receives a weighting of 1; the next oldest value receives a weighting of 2; and the next oldest value receives a weighting of 3, etc., all the way up to the most recent rate.
For example: If on Day1 the price = 77, Day2 = 79, Day3 = 79, Day4 = 81, and the current Day5 = 83
The demominator would be 1+2+3+4+5 = 15
And the 5 Day WMA would be: 77*(1/15) + 79*(2/15) + 79*(3/15) + 81*(4/15) + 83*(5/15) = 80.7
Some traders find this method more relevant for trend determination especially in a fast-moving market. The downside to using WMA is the resulting average line may be "choppier" than a simple moving average, which could make it more difficult to discern a market trend from a fluctuation and send a false trade signal. For this reason, some traders place both a simple moving average and a weighted moving average on the same price chart.
An exponential moving average (EMA) is similar to SMA, but whereas SMA removes the oldest prices as new prices become available, an exponential moving average calculates the average of all historical ranges, starting at the point you specify.
To calculate EMA, take current price and multiply it by a constant, C. Take previous period’s EMA and multiplay it by 1 minus that constant, C. Add the two values together.
If you are calculating your first EMA value where there is no previous day’s EMA, use SMA instead.
The formula for deriving the value of the constant, C is:
Adding MAs can help to clarify the overall shape of a trend, as shown in the EUR/GBP chart below. Remember, price moves in waves and can provide us with opportunities to join a prevailing trend as price pulls back to a level of equilibrium. MAs can help identify this equilibrium zone by smoothing out short-term fluctuations in price and highlighting the direction and momentum of trends.
The simple or exponential MA are the most commonly used and can be configured to an appropriate period to assess a trend on different time spans:
• Long term trend: 200 period MA
• Medium term trend: 50 period MA
• Short term trend: 10 & 20 period MA
OPTIMAL MA GEOMETRY
The correct geometry is an important aspect to note, in combination with a strong price action trend. Optimal MA geometry adds an extra layer of confirmation to finding the strongest trends. Optimal geometry includes indicators that:
• All MAs are either rising or declining in the ideal order
• All are rising or declining at a similar angle, with space in between each MA
• The MAs are fanning out
Note that we use MAs as dynamic trend lines, which - when combined with other factors - will indicate potential buy and sell areas, and a suitable price equilibrium level. In effect, we use MA geometry to filter out false or confusing trading signals.
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Using Moving Averages (MAs)
For traders dealing in a volatile, fast-moving market, the potential for false signals is a constant concern. The greater the degree of price volatility, the greater is the chance that a false signal is generated. Moving averages are essential to other types of technical analysis as well - most notably Bollinger Bands® and Stochastic measurements.
IDENTIFYING PRICE EQUILIBRIUM
The most common applications of MAs are to identify the trend direction, and to determine support and resistance levels. While many traders view MAs as indicators of market support and resistance, often this is not necessarily the case without taking into account other factors indicating confluence with the trend.
A rising MA can indicate an uptrend, with a declining MA can indicate the reverse. A bullish crossover, where a short-term MA crosses above a longer-term MA, tends to confirm upward momentum, with the opposite indicated when a short-term MA crosses below a longer-term MA in a bearish crossover. But note that MAs in themselves are not always the best indicators for entering or closing trades. Remember that, because MAs are a lagging indicator, the trend may have already reversed by the time these signals take shape.
In this chart, we included only two moving averages to keep clutter to a minimum, but in practice you can have as many moving averages of varying speed as you like. Some traders like to add a very-slow moving average, like 200, as this removes almost all fluctuations and shows a longer-term market direction.
TIMING TRADE ENTRIES
Once you have identified a chart with MAs that are in the ideal order, and that are fanning out, the next stage is to time a trade entry by identifying where the price is pulling back into the precise buy or sell area. A common strategy would be to trade at the best price possible – that is when price has retraced back into equilibrium.
You can use a 15 period MA to help identify areas of equilibrium between a 10 and 20 period MA.
Be aware that this MA area represents a dynamic level of equilibrium and is constantly changing. Prices may well tick over or under the MA, then continue in the primary trend direction.
In a trend, notice how price of EUR/CHF keeps pulling back to a certain level in the trend before moving on the original direction. This represents a pullback to equilibrium.
Remember that there are hundreds of thousands of traders and investors using MAs - especially the most common periods, i.e., 10, 15, 20, 50, 100 and 200. Their decisions could influence the direction of price - especially as many of them are likely to trade only on the MAs, without necessarily waiting for other converging or supporting factors.
The more tools you have in your trading chest, the better equipped you shoud be.
It’s also important to note that the further price moves away from its MAs, the greater the probability that it will snap back rapidly to its equilibrium position. An over-extended market is one that has made a significant move away from the mean and is therefore likely to suddenly revert back to the mean - just as would be the case if you stretched an elastic band and then let one end go.
If the market moves too far from the MAs, it’s usually best to wait for that pullback before looking to buy or sell. MA over-extension can be a useful indicator that it is potentially time to pull out of a trade.
CHOOSING THE NUMBER OF REPORTING PERIODS
The number of reporting periods included in the moving average calculation affects the moving average line as displayed in a price chart.
• The fewer the data points (i.e. reporting periods) included in the average, the closer the moving average stays to the spot rate, thereby reducing its value and offering little more insight into the overall trend than the price chart itself.
• On the other hand, the greater the number of data points included in the moving average calculation, the less any single rate can affect the overall average. A moving average that includes too many points evens out the price fluctuations to such a degree that a discernible rate trend cannot be detected.
Either situation can make it difficult to recognize reversal points with sufficient time to take advantage of a rate trend reversal. For this reason, it is important to select the number of data points that provides the level of price detail appropriate for the length of time you hold the trade open and your overall trading style. In this EUR/USD daily chart example, the fast 7-day SMA follows closely to the candlesticks, where the 180-day SMA shows a slow, steady, upward trend.
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