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 potential support and resistence levels, 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. Moving averages are typically plotted as price chart overlays, making them readily discernible. There are a handful of different moving averages, including the simple moving average (SMA) and the exponential moving average (EMA). In addition, the different types of moving averages may be used in more advanced indicators such as the moving average convergence divergence (MACD).
How Do You Calculate SMA (Simple Moving Average)?
In the realm of technical forex trading, there are a multitude of ways to calculate a simple moving average (sma). However, no matter which one is chosen, the simple moving average requires two essential inputs: length and source. The SMA's length or "period" is the number of intervals included in the calculation. This input is largely dependent upon the trading strategy being applied and may be denominated in ticks, minutes, days, or years.
The second facet of the simple moving average is the "source." The source, or source data, is a specific bit of information taken from past prices. Source data may be a periodic open, close, high, low or midpoint. Although many traders view the periodic close as being the most relevant aspect of price action, the trading strategy itself determines which source data is valid.
To illustrate the SMA calculation, let's start by gathering a security's closing prices over a fixed number of trading sessions or periods. Assume that it was an active month on the forex market and Trader A wants to apply a 20-day SMA to price action of the EUR/USD. The following equation will produce the appropriate moving average value:
- Pn = Price at period n
- N = Total number of periods
- SMA = (P1 + P2 + … + Pn) / N
- 20-Day SMA = (P1 + P2 + … +P20) / 20
If a trader wants to determine the 20-day simple moving average 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 simple moving average of the same currency pair would require totalling its closing values during that time and then dividing that sum by 200. In either case, the SMA gives the trader an idea of which direction price action is moving within the context of the broader forex market.
To calculate the SMA, one must start by gathering a security's closing prices over a fixed number of trading sessions or periods.
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.
How Do You Calculate EMA (Exponential Moving Average)?
Compared to the SMA, calculating an exponential moving average (EMA) is a bit more complicated, as this indicator gives greater weight to more recent price action 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 exponential moving average 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)
Among moving averages, the exponential moving average involves more advanced arithmetic. Fortunately for active forex traders, the modern software platform has automated most moving average calculations. All the user needs to do is select an SMA or EMA, define the inputs and apply the moving average to price action. The result is an easy to use indicator that is ideal for studying market behaviour or defining support and resistance levels.
What Is The Best Moving Average To Use In Forex?
One of the great things about moving averages is their flexibility in forex trading. No matter if one is an intraday, day, or swing trader, the moving average can help define market state or craft trade-related decisions. Also, there is no significant risk involved with choosing the wrong one; as long as it is applied to the forex market within the framework of a comprehensive trading plan, the moving average will function as it should.
However, there are differences to be aware of when deciding whether to utilise exponential moving averages or simple moving averages. Essentially, the SMA is designed to give the trader a broad view of the basic trends of past prices. All prices are weighted equally by the SMA, which can be problematic when dealing with evolving price action. On the other hand, the EMA places more emphasis on recent prices and weights them accordingly. Thus, the exponential moving average exhibits a greater sensitivity to current pricing volatility than does the simple moving average. This factor makes the EMA better suited for use in short-term trading strategies.
Conversely, the SMA is ideal for longer-term forex trading. By giving all periodic prices equal weight, previously important volatility is not discounted. In this way, one can gain a more accurate perspective of the macro picture instead of focussing solely on current price action.
While both moving averages can be used successfully inside a vast array of forex trading strategies, SMAs are better suited for longer-term trading while EMAs are more readily applied to shorter timeframes. Ultimately, your best moving average will depend upon your trading style, goals and resources.
How To Use 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 or a significant risk 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.
Best Time Period For Moving Averages
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 moving average window, as doing so will provide a sense of how the pair performed in this comparatively short time.
Ultimately, the task of selecting an appropriate periodicity falls upon the trader. No matter which types of moving averages are being used, it is critical to select an appropriate data set. Below are a few of the most commonly applied SMA and EMA time periods in relation to strategy:
- Intraday Trading: For intraday traders, time periods should be measured in ticks, minutes or hours. Among the best durations are 1, 5, 30, and 60-minute charts. Due to the compressed time frames, EMAs are usually favored by intraday traders.
- Day Trading: True day traders typically apply moving averages to 30-minute, 60-minute and 240 minute charts. For this discipline, both EMAs and SMAs are used.
- Investment: Long-term investors view time in terms of days, weeks, months and years. Given the extended horizon, the simple moving average is an indicator of choice.
Once again, it's important to understand that EMA and SMA values will diverge as periodicities become extended. To be successful in using these indicators, the periods and types of moving averages being used must compliment the overall trading strategy.
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.
FXCM Research Team
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