The Moving Averages in Trading

Moving Averages – A Renowned Tool Trading

These days, several tools and strategies are in use by Forex traders in order to make more profit. If a beginner trader is trying to enhance the profit margin in the Forex market and other markets too, then he should consider these tools and strategies. One of the most important of these tools are the Moving Averages, which currently play an important role for many traders as a common indicator to analyze the market. However, this is a tool that needs to be used correctly so that more profit can be generated as the trading signals could be safer. In fact, many traders really don’t know how to use moving averages for better profit and they lose money at the end. The utility of this indicator is that it can help the trader to determine the general trend direction for a specific period of time and also possible changes in the current market trends.

As its name suggests, moving averages are nothing more than the average price of an asset in recent periods. For example a 20 day moving average would be the average of the closing prices over the last 20 days. As the indicator is calculated every day, the moving average of today includes the current closing price and the previuos 19 closing prices, and at the same time, removes all other data (for this reason, is said to be a moving average). Basically, the moving average, then, is not nothing but an average of prices that is adjusted (or moved) every day.

As an average price, the moving average helps to reduce the noise or short-term volatility in price movements, and thus allows us to better assess the quality and direction of a trend.

There are different types of moving averages, however the most common and used by market traders are the Simple Moving Average (SMS) and the Exponential Moving Average which are described below:

Simple Moving Average (SMA) – Offering Equal Importance to the Points!

Two simple moving averages in a price chart of EUR/JPY. MT4 trading platform of Forex4you

The Simple moving average is also known as the SMA in the Forex market. There are several sorts of Forex indicators that are based on the MA or moving average. The simple moving average has been considered as a line that will generate after calculating the average set of number derived from the period points. For an example, the SMA of 10 registered on the daily chart can be generated by considering the closing price for the last recent 10 days. By averaging them, such data can be generated. Due to this sort of calculation a single point will appear on the chart. The last data point will be waived off on the 11th day and a new data will be accommodated on the chart. This sort of method can be accomplished again and again. As per the simple moving average or SMA each point will be offered equal importance. Due to the simplicity of the process many Forex traders prefer to utilize the SMA for their Forex trading business.

In order to calculate the SMA you will require to follow the formula mentioned below:

SMA = SUM (closing prices) / n,  where: n = the number of periods.

Forex Trend Trading With Simple Moving Average

Forex trend trading is a proven method to make some profits in Forex market as it is a established fact that is backed by several decades of the market research, which currency pairs (and indeed the other markets) move in the trends. In case, trend is up it then makes little sense buying, in case, trend is down it makes little sense to sell, and in case, there is not any trend then it might not be the good time for you to trade. Best method to get the accurate sense of an overall trend is looking at the long term chart like daily, weekly, and monthly chart as well as sees which way moving line is pointing. 

Whereas it might not be very practical to use the monthly chart to trade signals, it will allow you see in the fast glance where market is and where it is headed in case, trend continues. It is general rule to interpret trading signals, which longer the time of price chart is, more reliable trading signal is.

Exponential Moving Average (EMA)

Two simple moving averages in a price chart of EUR/JPY. MT4 trading platform of Forex4you

Exponential moving average or known as EMA is quite a familiar term for Forex traders. This is a kind of moving average that reacts really fast to the price change that has occurred recently with comparison to the common simple moving average. Among all the short term averages, it’s the 12 day and 26 day exponential moving averages have been considered as the most popular ones.These short term averages can be used to generate indicators such as:
  • Moving average convergence divergence.
  • Percentage price oscillator.
At the same time, 50 days and 200 days exponential moving averages can be used to denote the long term Forex trends. As per the EMA the recent data will get importance but with the SMA all the data will get equal importance. This is the reason why EMA reacts faster to the recent change in price. In order to calculate the EMA you will require to follow the below mentioned formula:

EMA(current) = ( (Price(current) – EMA(previous) ) x Multiplier) + EMA(previous)

Comparison between the EMA and SMA

Both types have their uses and benefits, but in general terms they have some opposite properties that in some cases can complement each other. For example, the EMA can give more false signals than thSMA because it moves more quickly with the price action, so the SMA would be better to avoid this, but this same feature makes the SMA to move more slowly and may give signals too late and cause the trader to enter the market when a movement is almost finished, so in this case an EMA would be better to enter the market as quickly as possible when it detects a new trend.

Deciding which Moving Average to use is up to you,  if you decide to use moving averages in your analysis. If you want quickly information, a short-period EMA would be best, however if you are looking for information on a long dominant trend, the best would be a long-period SMA.

It is common to use a set of moving averages with different periods of calculation. For example, we can use a long period moving average to provide us with the general trend prevailing in the market and a short period moving average to provide us information about the most current behavior of the price that can give us a good entry point into the direction of the main trend. This entry point would be a cross between two or more moving averages. In fact, a lot of trading systems (good and bad) are based on moving average crosses.

Trading signals with Moving Averages

Moving Average Crossovers

A few lines are needed to describe one of the most common strategies in the market used to produce trading signals: the moving averages crossovers. However, many more lines involves the choice of such moving averages and the rules of their use according to market behavior, for example depending on whether the market is in a clear trend of sideways.

As is known, in the moving averages crosses, a buy signal occurs when the shortest moving average(or price) crosses the longest moving average from below to above and the sell signal occurs when the shortest moving average (or price) crosses the longest moving average from above to below.
This simplicity contrasts with the many combinations of moving averages that can be taken into consideration, ranging from the simple cross of the price with a moving average to the crosses of multiple moving averages. And not only that, we can combine simple, weighted or exponential moving averages, to name only those which are more commonly used.

In general, these strategies work better in markets with clear trends, because in sideways markets the moving averages crosses produce many false signals. For this reason, many strategies that use these indicatores have been designed to secure precisely to be in a trend before entering the market at the risk of trading with a delay. Additionally, some strategies expect different and specific crossing situations and others filter the trading signals using other indicators.
Some of the most common trading strategies based on moving averages are the following:
  • Crosses of two moving averages: 6 and 14, 10 and 50, 10 and 70, 20 and 50, etc.
  • The Scott Lowry system that is based on the crosses of three exponential moving averages of 4, 18 and 40 periods.
  • A famous trader, Bolton Smith, use three moving averages of 5, 15 and 30 periods, which he calls harmonic moving averages.
  • Another trader, R.C. Allen created a famous trading system based on the crosses of three simple moving averages of 4, 9 and 18 periods. This system is widely used by traders of all markets including the Forex market and the stock market. 
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