12. How to use Moving Average
Moving Averages is yet another indicator used for technical analysis. Let’s understand how you can use Moving Averages to increase your profits in Forex Market. This one as with other indicators help you to be prepared before you place a trade.
Moving Average helps identify a trend in the movement of currency price. Using moving averages traders can identify new trends, whether it is uptrend or downtrend. As the name suggests, average closing price over a period of time forms the Moving Average. Moving averages also help in identifying if a trend is going to continue or reverse after a particular period of time.
The graph above shows a 2 period moving average drawn using the closing prices.
There are two types of moving averages:
- Simple Moving Average(SMA)
Simple moving average is very simple. Simple moving average is calculated by calculating the sum of closing prices for a number of periods for which you want to plot and then dividing the sum by that number.
For example, in a 1 hour chart if you plot 2 period moving average, you would add the closing price for last two hours and divide the sum by 2. Connect these averages for every 2 hour period and you have the 2 period moving average. Isn’t that simple.
One key point to understand is that there is always a delay associated with moving averages. The longer the moving average period, the farther will be the graph from the closing prices. Thus, moving averages give you a very broader view of the market and the trends.
- Exponential Moving Average(EMA)
Exponential moving average is similar to simple moving average in that it calculates the average, but it gives more value to the most recent time. It’s not much worried about the past. When irrelevant data is included in the calculation of moving average it actually gives a false impression to the traders about the price movement. Hence, exponential moving average gives more weight to the most recent data. It is also known as “exponentially weighted moving average”.
So, now you understand how Exponential moving average differs from Simple moving average. Consider a series of prices for a few days:
$10, $20, $30, $40
A 4 period SMA would be calculated as (10+20+30+40)/4 = $25
Did you notice something? Even though the most recent prices were $30 and $40, the SMA results in $25 which causes a lag. Since the prices were lower in the first few days, the moving average is a bit lagging from the actual price.
On the other hand, EMA gives value to the most recent data and hence reduces the lag.
Even though there are differences between Simple Moving Average and Exponential Moving Average, we cannot say that one is better than the other. Exponential Moving Average makes use of the recent data to reduce the lag, but Simple moving average is the true average of prices and hence is better suited to identify support and resistance levels. Ideal moving average to choose clearly depends on the trader’s objectives and strategies.
As we mentioned earlier, moving averages can be used to identify the trend. It is time to understand how. On a chart if the price is above the moving average, it is an uptrend and if the price is below the moving average, it is going to be a downtrend.
But do you know the problem? Hopefully you should be knowing that.Since simple moving average is simple, it can generate a false signal.
In the example above, initially we find that price is above the moving average and hence it signals an uptrend. But then may be that price change was only for that particular day. You find that you take a position and get into a loss due to a downtrend afterwards.
How can you solve this problem? Don’t worry we are here to help you and provide you with your answers. Traders plot multiple simple moving averages for different periods. We know that longer the time period, slower will be the moving average plotted. Now, consider you have two moving averages plotted obviously for two different periods. For an uptrend, the faster moving average will be above the slower one. Similarly for a downtrend, the faster moving average should be below the slower one.
You might be thinking, if moving averages can be used to identify trends, they should be able to tell you about trend reversals as well. Very true and if you really thought so, congratulations you are on track so far. In simple words, plot multiple moving averages on the chart and if you see that they crossover, it indicates that there are chances of a trend reversal. But please note, this might work during uptrends and downtrends. But when it comes to ranging there can be multiple crossovers and hence in such cases you should wait for the trend.
Alright, we are done. We are getting into conclusion. Huhhhhhh… Moving Averages ensure that as a trader you are following the current trend. As we have seen there are advantages and disadvantages associated with moving averages and hence they are used in conjunction with other tools during technical analysis to provide the best results.