Lesson 5 – Moving Averages
The Moving Average or (MA) indicator is the most frequently used indicator in technical analysis and surely one of the oldest technical indicators in existence.
A moving average is the average price of a market at a specific point in time.
A moving average shows the direction and length of a trend. The purpose of the moving average is to show the trend in a smoothed way.
Since the Moving Average is one of the most versatile and widely used of all technical indicators, it is the basis for most mechanical and discretionary trading systems in use today.
Here are some general characteristics of the Moving Averages:
The moving average is calculated with a certain predefined period.
The shorter the period is, the higher the probability of false signals
The longer the period is, the weaker the sensibility of the moving average is.
As its name implies, a moving average is an average of a changing body of data.
For example, a 50 day moving average “applied to close” is obtained by adding closing prices for the last 50 days being measured and dividing by 50.
It is a MOVING average, because only the latest periods specified are being used in the calculation.
Therefore, the data being analyzed forward with each new trading day.
Analysis of Moving Averages can be made to any of the following price kinds:
Opening Price:
The periods’ analysis is being made on each of the body’s opening price
Closing Price:
The periods’ analysis is being made on each of the body’s closing price
Highest Price:
The periods’ analysis is being made on each of the body’s highest price
Lowest Price:
The periods’ analysis is being made on each of the body’s lowest price
Median Price:
The periods’ analysis is being made on each of the body’s median price
Median Price = (High price + Low price) / 2
Typical Price:
The typical price of the calculated period is as following:
Typical Price = (High price + Low price + Close price) / 3
Weighted Price:
The weighted close price of the calculated period, this price calculated as following:
Weighted Price = (High price + Low price + Close price + Close price) / 4
Types of Moving Averages
There are four common type of Moving Average indicators:
- Simple
- Exponential
- Smoothed
- Linear Weighted
Simple Moving Average (SMA):
The Simple Moving Average is the most widely used Moving Average.
The Simple Moving Averageis sometimes called an arithmetic moving average and is basically the average price over a period of time.
It is calculated by summing the closing prices of the currency for a period of time and then dividing this total by the number of time periods.
For example the Moving Average of the last 10 days closing price is the addition of these prices divided by 10.
Because the Simple Moving Average gives equal weight to each price period being analyzed, the longer the time period studied, the greater the smoothing out of recent market volatility.
Here is an example of a GBP/USD 25 period MA
Exponential Moving Average (EMA):
The Exponential Moving Average indicator reacts faster to recent price changes than the Simple Moving Average due to the fact that it adds the current closing price to the previous value, giving the last prices more weighted value.
The period is used to determine the relative weight which previous values should be given. The formula is used to determine the percentage.
Here is the same example of the GBP/USD 25 period but with EMA:
Smoothed Moving Average (SMMA):
Since the Smoothed Moving Average indicator smoothes the MA by giving the recent prices an equal weighted to past prices, it is recommend to use the SMMA with longer periods for better results.
Here is the same example of the GBP/USD 25 period but with SMMA:
(Note how the curve is much more smoothed)
Linear Weighted Moving Average (LWMA):
A Weighted Moving Average is calculated by multiplying each of the previous day’s data by a weight. The weight is based o n the number of days in the moving average.
The Linear Weighted Moving Average indicator gives the latest data more weighted value than more early data.
The fact that it is measure linearly, means that the oldest value receives a weight of 1, the next value receives a weight of 2, the next value receives a weight of 3 and so on, till the last value which receives a weight equal to the period.
So in a 25 LWMA, the weight on the first day is 1.0 while the value of the most recent day is 25. This gives 25 times more weight to today’s price than the price 25 days ago.
Here is the same example of the GBP/USD 25 period but with LWMA:
How to trade using Moving Average Indicators:
The use of Moving Averages in Forex trading is a very, very, very wide topic, but these are the main ones, and the ones you will make money if applied correctly:
One important point to note here is that Moving Averages work better in trending markets and not so well in non trending markets, because you will get “whipsaws” which means false signals due to ups and downs within certain price. However, Moving Averages are used to tell you when a price is going to break, which leads us to the first point:
Breakout of Moving Average:
Buy when the price crosses upwards, the Moving Average. Best if there is a complete candlestick above the Moving Average.
Sell when the price crosses downwards, the Moving Average. Best if there is a complete candlestick below the Moving Average.
Cross of Moving Averages:
To trade the cross of moving averages, two or more MAs are needed
The smallest MA is known as the Fast MA and the bigger period MA is known as the slow MA.
In this example the Fast 25 MA is white and the Slow 50 MA is yellow.
Buy when the Fast 25 Moving Average crosses above the Slow 50 Moving Average.
Sell when the Fast 25 Moving Average crosses below the Slow Moving Average.
Power Tips
Remember to ALWAYS confirm your entry or exiting of trades with other Indicators, when using Moving Averages. These other indicators can be, but are not limited to: MACD, Momentum, RSI, Stochastics & Price ROC.
Whipsaws can be reduced, when using longer periods which will give us less trading signals but are going to be more true and sure signals.
Insert in your charts commonly used Moving averages like 10, 50, 100 & 200
Commonly used Moving Averages such as the 200 EMA are used also for support or Resistance levels, so be on the lookout for retracements when prices reach these levels.
