Simple Moving Averages (SMA)

Moving averages are used to smooth out price fluctuations and to give a clearer picture of the underlying trend. To accomplish this, the average of closing prices during a fixed period of time is calculated.

Here’s an example of how it is done if you want the closing average over the last 50 days:

1. Add up all the closing prices.
2. Divide the total (the sum) by 50 and you have the average closing price.

It is called a “moving average” because a new average is calculated with each new price bar. In other words, each day’s new closing price is added to the total and the earliest price bar is subtracted from the total. This procedure keeps the moving average figure up-to-date.

In Forex trading, the most popular time charts used to calculate moving averages are:

• 5 day (one week of trading)
• 20 day (approximately one month of trading)
• 50 day
• 100 day
• 200 day

Shorter moving average time periods react more quickly to trend-change direction than do longer time periods. Also, longer moving average time periods have a more noticeable smoothing effect and produce fewer false signals (whipsaws). Not unlike trend lines, the slope of a moving average reveals the strength of the current trend. Hence, moving averages are often referred to as “automated trend lines.”

Chart Source – Fxtrek IntelliChart™

Exponential Moving Averages (EMA)

With an exponential moving average more weight is given to the most recent price action. This enables it to be more responsive to changes in price direction. Below, is a comparison of a simple moving average and an exponential moving average:

Chart Source – Fxtrek IntelliChart™

• One for a 5 day period (short term)
• One for 50 days (medium term)
• One for 200 days (long term)

You should make it a daily practice to monitor all the averages for currency price developments.

How do moving averages produce trading signals?

• They interact with the prices or each other.
• A buy signal is generated when currency prices close above the average.
• A sell signal is generated when currency prices close below the average.
• A longer term moving average (100-day) indicates strong support (in an uptrend) and strong resistance (in a downtrend), trend continuation signals can be indicated when prices jump away from it.
• A buy signal is generated when a shorter term moving average crosses above a longer term moving average. In Forex terminology, this referred to as a “Golden Cross.” (You will need to use two moving averages with different time periods such as a 5 day and a 21 day to see this.).
• A sell signal is generated when a fast moving average drops below a slower average. This type of crossover is called a “Dead Cross.”

Chart Source - FXtrek IntelliChart™

Chart Source - FXtrek IntelliChart™

Moving averages are commonly used in trading system software because of their simplicity and objectivity in defining trends.

Advantages of using moving averages

• They trade in the direction of the trend.
• They allow profits to run and they cut losses short.
• The moving average system gives the trader a set of rules, which when followed, provides him or her specific buy and sell signals.

But which is better: Simple (SMA) or Exponential (EMA)?

Let’s compare.

Simple Moving Averages:

• It displays a smoother moving average on the chart than an exponential moving average does.
• If you want the moving average to respond more slowly to price action, you can use a longer-period SMA to do it.
• Because it moves slower, it can save you from many fake-outs.
• But because it is slower, you might not see early indicators for a good trading opportunity.

Exponential Moving Averages

• Even though it displays a “choppier” moving average on the chart, a short-period EMA will respond quicker to price action than an SMA. This means you will have a better chance to catch a trend early and have the potential to make more profit on the trade.
• However, the risk of being faked out is higher because its quick price-action response could mislead you into thinking a trend is forming when it is not. It could merely be a price spike.

To deal with this dilemma, you can plot more than one moving average to make comparisons and get a better sense of what is happening. For example:

• You could plot a longer-period SMA to help you identify the overall trend.
• At the same time, you could plot a shorter-period EMA to look for a good buy/sell opportunity.

As always, it is recommended that you sign up for a free demo account with a good Forex broker and do some risk-free experimentation in real time. Practice is one key to successful Forex trading.

The importance of moving averages

Among professional Forex traders, they are one of the most widely used technical indicators. This fact alone should encourage traders to put them in their Forex toolbox and use them – at the very least as a cross-reference. There are many good Forex books and Forex courses available if you want additional information and instruction on moving averages.