Tuesday, July 30, 2013

Trading with Moving Average

A moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.

The two major types of moving averages:
1. Simple
2. Exponential
Simple moving average (SMA) 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. Here is an example of how moving averages smooth out the price action. On chart above, we have plotted three different SMAs on the 1-hour chart of USD/CHF. 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 SMAs.
This is because the 62 SMA adds up the closing prices of the last 62 periods and divides it by 62. The longer period you use for the SMA, 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. Here, we can see that the pair is trending.
Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging.

Exponential moving averages (EMA) give more weight to the most recent periods. In our example below, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.

Let's say we plot a 5-period SMA on the daily chart of EUR/USD. The closing prices for the last 5 days are as follows: Day 1: 1.3172
Day 2: 1.3231
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293

The simple moving average would be calculated as follows:
(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209

Well what if there was a news report on Day 2 that causes the euro to drop across the board. This causes EUR/USD to plunge and close at 1.3000. Let's see what effect this would have on the 5 period SMA.
Day 1: 1.3172
Day 2: 1.3000
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293

The simple moving average would be calculated as follows:
(1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163

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 was just a one-time event caused by the poor results of an economic report.

This would mean that the spike on Day 2 would be of lesser value and wouldn't have as big an effect on the moving average as it would if we had calculated for a simple moving average.
If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders are doing recently.

Let's take a look at the 4-hour chart of USD/JPY to highlight how an SMA and EMA would look side by side on a chart. Notice how the red line (the 30 EMA) seems to be closer price than the blue line (the 30 SMA). This means that it more accurately represents recent price action. You can probably guess why this happens

It is because the EMA places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing NOW rather what they were doing last week or last month.

Remember, using moving averages is easy. The hard part is determining which one to use!

That is why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want use them as dynamic support and resistance.

Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.

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