The Moving Average is very important in forex trading. Read forex technical trade analysis and, again and again, you’ll see references to moving averages. The computers that move most of the money on the forex market are programmed to track moving averages – this means you had better notice them too.
The advantage that moving averages give you is that they smooth out “market noise.” You want to isolate the trend, but forex prices often go through anti-trend variations before falling back on the trendline. Using moving averages, you can look through very short-term changes and keep your bet alive on the real trend. No, it doesn’t always work, but you’ll be on the right side of probability if you stick with moving averages.
You are probably familiar with the mathematical concept of “averages” from your high school math days.
To find the mean average of a set of numbers (there are other kinds of averages), you add them up, count how many there are in the set, and divide the sum of all the numbers by the total number. For the set 1234567, the average is the sum=28/7=4.
The mean average is what forex traders use to calculate what is called the “simple moving average.” Start with the chart you want to work on: Let’s say the one-hour chart. You want the moving average for a 24-hour period. You add up the closing prices from each hour, and you divide by 24.
If you plot this on the chart – there’s a tool available on most forex trading platforms – you’ll see the general direction of the price action. Working with a simple moving average, the shorter the time period, the closer it will be to the price movement.
You get a sense, from this, of the overall sentiment on the market, but you have to watch for extreme movements that buck the trend. If for some reason, one closing price is much lower or higher than the others, your calculation will be off. This happens when something affects orderly trading – you know, a major announcement, for example, from a central bank that causes an extreme price change.
Long-term traders often use the 100-day or 200-day simple MA, but many forex traders prefer the 50-day exponential moving average which is closer to short-term trends.
Here’s a recent example: “USD/CAD was supported by the 200-day (MA) this week before turning higher…”
The Exponential Moving Average
An exponential moving average for a short period will stay closer to the price changes than a simple moving average.
You don’t have to make this calculation, as the platform will have a tool to do it for you and to draw the trendline. But here’s how it works:
The exponential moving average (EMA) is a weighted average of the last n prices, where the weighting decreases exponentially with each previous price/period. In other words, the formula gives recent prices more weight than past prices.
Exponential moving average = [Close – previous EMA] * (2 / n+1) + previous EMA
For example. a four-period EMA with prices of 1.5554, 1.5555, 1.5558, and 1.5560, with the last value being the most recent, gives a current EMA value of 1.5558 using the calculation [(1.5560 – 1.5558) x (2/5) + 1.5558 = 1.55588].
What you get from the exponential moving average
Moving averages can be used for both analysis and trading signals.
As we’ve seen, both moving averages help you to isolate the trend, although the exponential is closer to it. When the price of a currency pair crosses above its moving average, it suggests that the price will keep on moving higher, so it indicates an upward trend. And vice-versa when it crosses below a moving average – think downward trend.
It’s useful to put a long- and a short-term moving average on a chart together, and wait to see which one crosses the other – this too will give an accurate trend indication.
In a sustained uptrend, the currency pair price generally remains above the 50-day moving average, and the 50-day MA remains above the 100-day moving average. If the currency pair price falls sharply below the 50-day moving average, which remains below the 100-day moving average, it signals a pretty sharp downward trend.
And moving averages are often combined with other indicators to form a new one – as in the Keltner Channel.
There is no one right choice for moving averages as an indicator. You should understand the differences among the various alternatives, and choose one that fits your strategy.