Moving Average is an extremely popular indicator that is commonly featured in trading platforms. It helps trader to understand the overall pattern of price movement.

In forex trading, there are many ways to recognize the trends. One of them is through technical indicators. But we have a whole lot of them, so which one? Some of the most common indicators used to predict trends are Moving Averages (MA), Moving Average Convergence-Divergence (MACD), Bollinger Bands, Fibonacci Retracements, and Relative Strength Index (RSI). This article will talk about Moving Average.

Moving Average is an extremely popular indicator commonly featured in trading platforms. It helps traders to understand the overall pattern of price movement by smoothing out price fluctuations. It is created by comparing past prices during a specific period. There are at least three ways of doing this:

  1. Simple Moving Averages (SMA)
  2. Exponential Moving Averages (EMA)
  3. Weighted Moving Averages (WMA)

Although nowadays, we don't have to bother counting MA manually, you should understand the concept well by scrutinizing the following explanation.

 

Simple Moving Averages

SMA calculates average prices through usual measures. First, you choose how long is the time period. SMA-5 daily, for example, means you make an average out of the last five days' prices.

SMA-5 Daily = (Day 1 + Day 2 + Day 3 + Day 4 + Day 5)/5

To count tomorrow's movement, discard that first day and add today's price. For the following days, you do that continuously. Now, you may wonder, which price? You could use any price; high, low, closing, opening, or whatever suits your taste. Below is an example of SMA-5 Daily with closing prices.

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The direction of the line shows us the current trend, whether uptrend or downtrend. If the price moves under the line, it means the price is in downtrend. If the price moves over the line, then it is in uptrend.

A single MA shows the trend, but you could maximize the SMA to detect buy/sell signals by adding SMA in another period, such as SMA-21 Daily (an average of prices in 21 days). See the following picture to get the idea.

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The above picture shows buy signal when SMA-5 line cuts SMA-21 line on its way upward. The sell signal appears when SMA-5 line cuts SMA-21 line on its way downward.

 

Exponential Moving Averages

If SMA gives equal treatment to each price used, then EMA distributes weight to each price according to its period. Here is how we count the weight if we want to count 5-day EMA:

EMA% = 2/(n+1)x 100%

Afterward, you calculate each day with this formula:

EMA = (n price - previous EMA) x EMA% + previous EMA

The longer the time frame you choose, the line will move slower. Five or ten days could move quickly due to its sensitivity to the ongoing market. But 100 or 200 days certainly is going to be much slower. Please note that the more sensitive it is, the higher the probability of error (false signal). Manipulating Moving Average is ordinarily done by adjusting the time.

 

Weighted Moving Averages

WMA also distributes weight to each period, like EMA. However, in WMA, we allocate different weight according to its period in sort ascending. It might be easier to understand with an example. Say, we want to count 5-Day WMA. Price from the first to the fifth day are: (82.22) (82.14) (83.58) (83.58) (83.69).

To count them, we must first determine the ratio we will use.

The numerator is n period, and the denominator of five days will be: (1+2+3+4+5) = 15. So the ratio is (n/15)

The WMA-5 will be: 82.22(1/15) + 82.14(2/15) + 83.58(3/15) + 83.58(4/15) + 83.69(5/15) = 83.33

Huft, that was quite confusing, wasn't it!? WMA could be called standardized Moving Averages. However, it is more complicated than SMA and EMA, and that's why it is less popular than the others. But some traders combine SMA and EMA or WMA, because they are quite lethal in making all the necessary predictions.

Moving Averages, in general help predict the direction of the trend, identifying support and resistance level, detecting penetration of a certain price level (breakout), and measuring price movement momentums.

 

Previous articles in this series:

  1. Predicting Trends Using Stochastics in Forex Trading
  2. Predicting Trends Using Pivot Points In Forex Trading