A moving average is simply a way to smooth out price action overtime.
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.
As we said, moving averages smooth out price action.
There are different types of moving averages and each of them has their own level of "smoothness".
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it is to react to the price movement. To make a moving average smoother, you should get the average closing prices over a longer time period.
In this section, we first need to explain to you the two major types of moving averages:
1. Simple
2. Exponential
It’s important you know how to calculate them and give the pros and cons of each. It’s of great benefit for you to know the basics first.
So let me dive into it right away.
Simple Moving Averages
A simple moving average is the simplest type of moving average.
Even though you won’t be needing to calculate what I am about to explain now because the software will automatically do that for you, I just want to give you a heads up so you know what is happening behind the software when you plot it on your chart.
Here we go..
A simple moving average is calculated by adding up the last "X" period's closing prices and then dividing that number by X.
Lost?
Just read along.
IMAGE OF WHAT A MOVING
AVERAGE LOOKS LIKE ON A CHART.
If you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average!
That’s what it does.
If you were to plot a 5-period simple moving average on a 10-minute chart, what the software does is to add up the closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, the software adds up the closing prices of the last 150 minutes and then divides that number by 5.
If you were to plot the 5-period simple moving average on the 4 hr, the software adds up the closing prices of the last 20hours and then divides that number by 5.
You get the picture!
All Forex platforms will do the calculations for you. The reason I explain it as background information is for you to understand so that you know how to edit and tweak the indicator when you start using it.
Understanding how an indicator works means you can adjust and create different strategies as the market environment changes.
Now, just like almost any other indicator out there, moving averages operate with a delay. Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of "future" short term price action.
Here is an example of how moving averages smooth out the price action
Notice how the 50 SMA is farther away from the current price than the 20 and 10 SMAs.
This is because the 50 SMA adds up the closing prices of the last 50 periods and divides it by 50. The longer period you use for the SMA, the slower it is to react to the price movement.
The SMAs in this chart shows you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.
Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of Simple Moving Averages, we can tell whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average and it's that they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new trend may be developing but in reality, nothing changed.
Let’s take a look at another type of moving average.
Exponential Moving Average
So while the simple moving average places emphasis on the closing of prices which makes it a bit slow but gives us the general trend, the exponential moving averages (EMA) give more weight to the most recent periods. It puts more emphasis on what traders are doing recently.
Let's take a look at this chart to highlight how an SMA and EMA would look side by side on a chart.
It's because the EMA places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing at the moment rather than what they were doing last week or last month.
Let me quickly explain the difference between the two.
First, let's start with the exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go.
These can help you catch trends very early, which will result in higher profits. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits.
The downside to using the exponential moving average is that you might get faked out during consolidation periods.
Because the moving average responds so quickly to the price, you might think a trend is forming when it could just be a price spike. This is because the indicator is just too fast.
With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.
This would work well when looking at longer time frames, as it could give you an idea of the overall trend.
Although it is slow to respond to the price action, it would do well in saving you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good entry price or the trade altogether.
This is left to the trader to decide based on what they want to see in the price.
Traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.
There are a number of trading strategies that are built around the use of moving averages. I will be taking a look at these in the following lessons.
I will teach you on:
1. How to use moving averages to determine the trend
2. How to incorporate the crossover of moving averages into your trading system
3. How moving averages can be used as dynamic support and resistance
One sweet way to use moving averages is to help you determine the trend.
The simplest way is to just plot a single moving average on the chart. When price action stays above the moving average, it would signal that price is in a general uptrend.
If price action stays below the moving average, then it would indicate that it is in a downtrend
Let me explain.
In a downtrend, the "faster" moving average should be below the "slower" moving average and for an uptrend, vice versa. For example, let's say we have two SMAs: the 20-period SMA and the 100-period SMA. On your chart, it would look like this:
Moving Average Crossover Trading
By now, you know how to determine the trend by plotting on some moving averages on your charts. You should also know that moving averages can help you determine when a trend is about to end and reverse.
All you have to do is to load up a couple of moving averages on your chart and wait for a crossover. If the moving averages cross over one another, it could signal that the trend is about to change soon, thereby giving you the chance to get a better entry. By having a better entry, you have the chance to profit from the trade.
Note, when price is trending downwards or upwards for an extended period of time, you would make money using the moving average crosses has your entry points. But when the price is trending sideways which we get to experience sometimes, then the crosses won’t be effective because you would experience multiple crosses that won’t lead anywhere.
Moving averages can also be used as a support and resistance level.
Due to the fact that the moving average works alongside the price and not static like your traditional support and resistance, it is referred to as dynamic support or resistance. They are constantly changing depending on recent price action.
Some traders look to moving averages as key support or resistance. These traders will buy when the price dips and tests the moving average or sell if the price rises and touches the moving average.
Take a look at the chart below.
It looks like it held really well! Every time price approached the moving average and tested it, it acted as resistance and price bounced back down.
One thing you should keep in mind is that these are just like your normal support and resistance lines.
There are also times when the price will blast past it altogether and won’t acknowledge the moving average.
Now you know that moving averages can potentially act as support and resistance. Combining a couple of them, you can have yourself a nice little zone. But you should also know that they can break, just like any support and resistance level!
Let's take another look at the chart below.
In the chart above, we see that the 50SMA, 100SMA, and 150SMA held as a strong resistance level for a while as price repeatedly bounced off it.
So there you have it, folks!
Moving averages can also act as dynamic support and resistance levels.
One nice thing about using moving averages is that they're always changing, which means that you can just leave it on your chart and don't have to keep looking back in time to spot potential support and resistance levels.
Why don't you open up your charting software and try popping up some moving averages here.
Remember, using moving averages is easy. The hard part is determining which one to use!
That's why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want to use them as dynamic support and resistance.
Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.
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