Moving averages help forex traders make effective transactions by aiding them in evaluating the price history of a currency pair or related investment. More specifically, these averages make it easier for investors to interpret the price fluctuations of an asset by smoothing out their random movements.
Technical analysts have harnessed a wide range of indicators over time, but the moving average stands out due to it being simple, practical and useful. By using it, forex traders can identify the price trends, as well as the resistance and support, of the security in question.
What Is A Moving Average?
A moving average is a type of lagging indicator that accumulates past price points and then averages them to provide a technical analyst with a better sense of where a security went over a period of time. There are a handful of different moving averages, including the simple moving average (SMA) and the exponential moving average (EMA).
Calculating The SMA
To calculate the SMA, one must start by gathering a security's closing prices over a fixed number of trading sessions.
If a trader wants to determine the 20-day SMA of the EUR/USD, he can add up all the currency pair's closing prices over the time and then divide by 20. Alternatively, figuring out the 200-day SMA of the same currency pair would require totalling its closing values during that time and then dividing that sum by 200.
Calculating The EMA
Calculating the EMA is a bit more complicated, as this indicator gives greater weight to more recent values in order to reduce the effect of lag. To determine this moving average, a forex trader should begin by selecting a time period, for example 10 days, and then calculating its SMA.
Next, the investor should figure out the multiplier he will use to give the most recent data points greater emphasis. The size of this multiplier will depend on how long the EMA is.
To calculate the multiplier, one can use the following formula:
- Multiplier = (2/(number of time periods) + 1)
- For a 10-day EMA: (2/(10 + 1)) = 0.1818 or 18.18%
- For a 20-day EMA: (2/(20 + 1)) = 0.0952 or 9.52%
Once this multiplier has been acquired, the following equation can be used to determine the EMA:
- Multiplier x (closing price - EMA(previous day)) + EMA(previous day)
Harnessing Moving Averages
Once a forex trader has calculated one or more moving averages for a security, he can use it for a wide range of purposes. Many investors utilise these indicators to determine what trend a security is following.
For example, a currency pair could follow an uptrend, or period of rising values, during a time frame. Most investors seek to identify these trends and then try to profit from them. Alternatively, a security may do the opposite and follow a downtrend over a period. When an investment behaves this way, it can create losses for any people or institutions owning it.
However, investors should keep in mind that whether a security is rising or falling in value, there are many different ways they can try to generate returns from either its rise or descent. For example, as long as assets are climbing in value, investors can simply buy them and obtain profits. They can also generate returns from depreciating securities through strategies such as shorting.
Using Different Time Periods
It is worth noting that forex traders with different preferences may employ moving averages of varying length. For example, someone looking to invest over the long term may look at how a security performs over a time frame such as 200 trading days, as this will grant insight into how the financial instrument has performed in the long run.
Alternatively, an individual focusing on short-term trading might hone in on how a currency pair did during a 20-day window, as doing so will provide a sense of how the pair performed in this comparatively short time.
One more use of moving averages is measuring the momentum of a given security's price, or how quickly it is either ascending or descending. The whole point of determining momentum is that once an asset starts moving in a certain direction, it will likely keep going the exact same way.
If a forex trader can identify the momentum of a security, he can buy or sell the asset, or even take out long or short positions on it. To single out this momentum, an investor can look at what the financial instrument did within the short, medium or long-term.
For example, if a forex trader wanted to ascertain the short-term momentum of the EUR/USD, he could look at either its 20-day SMA or EMA. If he instead desired a better sense of the pair's long-term momentum, he could look at a measure that used a period of 100 days or more.
Support and Resistance
One more benefit of moving averages is that they can be used to determine an asset's support and resistance. Securities will often find support at important moving averages. For example, if the USD/JPY recently increased over the course of a week and then this upward trend gave way to a sharp drop, the currency pair might find support at its 200-day moving average.
Many forex traders will expect securities to find support once they reach key averages and use other indicators in order to back up their forecast. In addition, these same investors will frequently make use of important averages to predict when currency pairs will run into resistance during their upward climbs.
For example, if a security drops below a key level of support, such as a 200-day moving average, the financial instrument will often have a difficult time rising above this important level. When an investor observes this situation, he can use it to either take profits or alternatively try to generate returns through shorting.
If investors take the time to master the moving average and the many benefits it provides, they will have access to a wide range of tools they would not be able to harness otherwise. With these implements, forex traders can make better-informed decisions and increase their chances of meeting their investment objectives.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.