What are Moving Averages
Moving Average is among the oldest form of technical analysis used to assess trend and to date, it is a commonly used indicator. Moving averages simply smoothen out price action over a period of time. In other words, it reduces the market noise or rather fluctuations that make obtaining accurate real-time exchange rate data difficult. By smoothening these fluctuations, it becomes easier to authenticate and identify potential market rate trends from the price fluctuations found in all currency pairs.
More technically speaking, it involves obtaining the average closing price of a currency pair within a particular period. It is used by traders to forecast future prices by studying the slope of the moving average to determine the possible direction the market prices will take.
Having a smoother moving average means that the price movement in the market is slow. On the other hand, a noisy moving average means that it reacts to the price movement faster. A smooth moving average is more desirable to make more accurate predictions; it is achieved by obtaining the closing prices average over a longer time period. There are various types of moving averages with each having its own level of “smoothness”. The two major ones are simple and exponential moving average.
Simple Moving Average (SMA)
This is the most basic type of moving average. It is attained by summing up a series of reporting periods or prices and then dividing the total of the sum by a specific number of data points. The formula simply calculates the average market prices within a specific period of time and adjusts in response to the most recent data. For instance, when obtaining the average calculation for the most recent 20 exchange rates, the oldest rate is automatically eliminated when a new price is available. As such, the average price keeps �moving’ every time a new price is included in the calculation. Thus, the average is always obtained using only the last 20 prices.
So if you are to plot a 1-hour simple moving average chart with 6 periods, all you need to do is sum up the closing prices for the last 6 hours, and then divide the total by 6. This will give you the mean closing price for the last 6 hours. If you join these averages together on the chart, you get the moving average.
Exponential Moving Average (EMA)
It is similar to the simple moving average, apart from the fact that Exponential Moving Average does not eliminate oldest prices in the calculation when new prices become available. EMA calculates the average of all data within a specified range.
For instance, let’s assume that you want to plot an exponential moving average of 15 reporting periods on a price chart. The first result of the exponential moving average will be similar to that of the simple moving average which is also based on 15 periods. However, when a new price becomes available, EMA will calculate the average of the 16 prices. Thus, there are now 16 reporting periods while SMA reporting periods still remain 15.
How to Use Moving Averages to Find the Trend
One of the major functions of moving averages is to identifying the current market trends. This also includes generating the actual trading signals and identifying resistance levels. The easiest way to achieve this is to plot the moving averages on a chart. The moving average slope can be used to gauge the strength of the trend. A price UPTREND occurs when the price movement remains above the moving average. On the other hand, in a DOWNTREND, price action is typically below the moving average.
An important thing to note when using moving averages to establish the trend is that, they are lagging indicators; they confirm established trends and not predict new trends. Many technical analysts and traders often consider holding a long position in an asset and analyzing multiple moving averages when trying to establish the long-term trends.
Use Moving Average Crossovers to Enter Trades
Having learnt how to determine trend by plotting simple moving average charts, let us advance to the next level; to determine when to enter or exit a trade. This is mainly triggered by a crossover that occurs when the short-term moving averages either cross above or below the long-term moving averages. A crossover is often a signal that the trend is about to change, and thus gives traders a chance to get a good entry.
Can Moving Averages be used as Dynamic Support and Resistance Levels
Yes, you can use moving averages as dynamic support and resistance levels. The term dynamic is used because the resistance lines keep changing with the changes on recent price action, unlike the convectional horizontal lines. Traders often use these lines to determine when to sell or buy; they sell if price touches or rises above the moving average and buy when the prices go below the moving average.
It is important note is that these lines can be as volatile just like the normal resistance lines. That is, the prices will not always respond as expected relative to the moving average; it can spike above or below the MA and then retreat back to the prevailing direction of the trend. Traders use them for dynamic support and resistance Levels by highlighting two moving averages and only buy or sell when the price is in the zone between the two specific points in the moving averages.
Just like every other indicator, a moving average is used forecast future market prices. It achieves this by reducing the market noise or rather fluctuations that make accurate prediction of real-time exchange data difficult. By smoothing these fluctuations, it becomes easier to authenticate and identify potential market rate trends from the price fluctuations found in all currency pairs. One of the major functions of moving averages is to identify the current market trends. This also includes generating the actual trading signals and also identifying resistance levels. While the moving averages lag behind the market spot rate, they give the traders a broader view. Their greatest contribution is that they help distinguish real market reversal points from normal exchange rate fluctuations and also help determine the strength of the current market trend.