MOVING AVERAGES
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.
UNDERSTANDING MOVING AVERAGES
Moving averages – whether simple, weighted, or exponential – are all lagging indicators. This means that they are based on events that have already occurred in the market as opposed to predictive indicators used to form an opinion on future market direction.
While moving averages do lag behind the spot rate, their real contribution is helping to determine the strength of the current market trend and to distinguish true market reversal points from typical exchange rate fluctuations.
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.
3-TYPES OF MOVING AVERAGES
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SIMPLE MOVING AVERAGE (SMA)
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WEIGHTED MOVING AVERAGE (WMA)
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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:
INTERPRETING MOVING AVERAGE SIGNALS
When using spot rate and moving average cross over trading signals, it is important to keep two points in mind:
MARKET VOLATILITY
Depending on market volatility, cross overs can be extremely unreliable so it is advisable to seek additional confirmation before acting. In the buy and sell examples below we examined here, the formation of a double-top and a reverse head-and-shoulders pattern helped confirm the market direction.
REPORTING PERIODS
The number of reporting periods included in the moving average calculation can have a tremendous effect on the moving average. The basic rule to remember is that the fewer the number of reporting periods, the closer the average stays with the spot rate.
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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.
BUY SIGNALS
When the spot rate crosses over the moving average, it may indicate that the spot rate is trending upwards as it is increasing at a faster rate than the moving average. This is typically seen as a potential buy opportunity.
Again, it is wise to confirm the analysis. In this example, the reverse head and shoulders pattern is a common rate reversal signal.
SELL SIGNALS
When the spot rate crosses under the moving average it suggests that the market price is losing momentum and is under-performing when compared to the moving average, indicating a sell signal.
The fact that the double-top chart pattern occurs at roughly the same point in this example reinforces the level as a likely sell opportunity.
MULTIPLE CROSSOVERS
Traders can place several moving averages on the same price chart. Typically, the faster moving average consisting of fewer data points will be selected, as well as a slower moving average. In this chart for example, the slower SMA is set at 30 days, and the faster SMA at 7 days.
When the fast moving average crosses above the slower moving average is considered a buy signal. Conversely, when the faster moving average crosses below the slower moving average, it is considered a sell signal.
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.
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