A moving average is a technical, trend-following indicator used to smooth short-term data by filtering the noise in random price fluctuations and thus creating a series of averages.
Moving averages do not predict future trends, but they help Forex traders understand the direction of the current trend with a lag, as moving averages are based on past prices rather than current ones.
Moving averages, commonly referred to as MAs, are calculated by averaging a number of past data points, which forms smoothed data on the chart and help traders look into the bigger picture by analyzing long-term trends or cycles rather than short-term price fluctuations.
To understand the potential of moving averages, know that they are the building blocks for other indicators and overlays, such as MACD and Bollinger Bands.
Moving Average Types
The most known types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA), which are used to gauge the direction of the trend and unveil potential Support and resistance levels.
Simple Moving Averages (SMA)
A Simple Moving Average (SMA) is the simplest form of moving averages in Forex analysis. It is calculated by dividing the sum of the closing prices of a period X by the number X.
Complicated? Not really. Here’s an example:
If you’re trying to plot a 5-period SMA on a 1-hour chart, you need to add up the closing prices of the past 5 hours then divide them by 5.
So, if the closing prices are 132.00, 133.00, 131.00, 130.00, and 135.00, the simple moving average would be 132.20.
Not that hard, is it?
Also, being a moving average, old data gets dropped as you move on, which makes moving averages and ever-evolving indicator.
Connecting these ever-evolving prices (dots) gives us a moving average across the chart.
Calculating the SMA for an entire chart can take a lot of time, but you needn’t worry as most charting packages would do the heavy lifting for you.
Simple moving averages help Forex traders see the broader view and identify whether the trend is going up, down, or just ranging, rather than focusing on the current price of the pair.
There is one problem with SMAs though, which is that they are susceptible to spikes, which may give the illusion of a change in the trend while nothing’s really happening.
What does that mean, you may ask?
Well, let’s explain it using an example.
Say you’re plotting a 6-period SMA on a 1-day chart, where the closing prices for the last five days are: 1.3564, 1.3571, 1.3578, 1.3584, 1.3589, and 1.3598. The SMA here would be 1.3580.
Now, let’s imagine that an event, say a news report, on the third day caused the Euro to drop, which got the EUR/USD pair to close at 1.3200. So, the new closing prices for the last five days are 1.3564, 1.3571, 1.3200, 1.3584, 1.3589, and 1.3598, which brings the new SMA to 1.3517, which is significantly lower than 1.3580, isn’t it?
Such a drastic change or spike would signal a potential downtrend, while day 3 was actually just an exception.
All of that to prove that SMA can prove to be too simple sometimes, which raises the need for something that would filter out those spikes to give more accurate averages. Thankfully, there is something like that; the Exponential Moving Average or EMA.
Exponential Moving Average (EMA)
Unlike SMA, which gives equal importance to the closing prices of the recent days, EMA puts more weight on the values of the most recent ones.
In our example, the spike on day 3 wouldn’t be as important as the values of day 4, 5, and 6, which makes the EMA more accurate than SMA, as it focuses on what the traders are currently doing, not what they were doing in the past days.
When it comes to Forex trading, focusing on the recent price action and how traders are currently behaving is far more critical than gauging what they were doing days or weeks ago, which makes EMA more accurate than EMA in this field.
Using Moving Averages to find the trend
Finding the trend using moving averages couldn’t be easier. All you have to do is plot a single MA on the chart, and you’re good to go.
If the price action is inclined to stay above the MA, the price is in an uptrend. Which is the case for this USD/JPY price chart.
If the price action is inclined to stay below the MA, it signals that the price action is in a downtrend. Which is the case for this USD/JPY price chart.
Simple, right? Actually, it’s way too simple, as it’s prone to false signals because of price spikes, just like when dealing with SMA.
So, taking our above example, if the EUR/USD pair is in a general uptrend, moving well above the moving average, but suddenly a news report gets the price to plunge and get below the MA, you’re most likely to think to yourself that a downtrend is coming and that you should short-sell while you can. The problem is, once the effect of the news reports wears off, the price will go back to the general uptrend, which would cause huge losses for you.
Many professional Forex traders try to overcome this by plotting more than one moving average on the chart, which gives a clearer signal regarding the general trend.
We recommend you do that as well. To make sure everything is working as it should, the faster moving average should be above the slower MA in an uptrend and the opposite in a downtrend.
If you have a 5-period MA and a 10-period MA, the first should be above the latter in an uptrend, and vice versa in a downtrend.
Keep in mind that you shouldn’t only rely on MA while planning your moves, as other indicators and your own knowledge and due diligence are required as well.
Moving Average as Dynamic Support and Resistance
Moving average can also be used as dynamic support and resistance levels. Unlike the traditional horizontal support and resistance lines, MAs are dynamic, meaning that they change over time.
Many professional Forex traders use moving averages as support and resistance, applying the same usual rules: if the price goes up and touches the MA, the trend is most likely to bounce and hit the opposite direction. If, on the other hand, the price dips and touches the MA, an uptrend is most likely to appear. Here’s an example of a GBP/USD chart in which the MA is used as a support level:
Also, as with typical support and resistance levels, the price won’t always bounce perfectly upon reaching the moving average. Sometimes it will breach it before moving in the opposite direction.
In some instances, the price may even breach the moving average all together, that’s why some traders use two moving averages instead of one, and they buy or sell when the price gets between the two lines.
The biggest advantage of using moving averages as support and resistance levels is that they’re ever-changing, meaning that you won’t have to go back every time looking for potential support and resistance levels.
It may seem easy on paper, but it actually requires some brain power to determine which moving average to use. As no rules are set on stone when it comes to Forex, you need to check the charts, analyze the data, and refer to your previous knowledge to determine what works for your analysis and what doesn’t.
Moving Average Crossover Strategies
To put it simply, when two or more moving averages that you plotted on a chart cross, it signals a potential reversal in trend direction, which presents a perfect opportunity to enter the market.
Keep in mind that nothing is certain, and while you may end up with a huge profit, you can also end up with a significant loss, so make sure to have a plan before making your move.
What some traders do instead of short or long selling is closing out their position when they spot a crossover or once the price has moved a predetermined amount of pips against the position. Why? Because no one can know for sure when a crossover is going to take place, and one may end up in a great loss if they wait too long.
It’s worth mentioning that while crossover strategies are great in volatile and/or trending environments, they are not of significant efficiency when the price is ranging, as you will end up with tons of crossovers before catching a trend again.
Again, due diligence and planning aren’t to be taken lightly. Don’t rely on a single indicator when you’re trading, as that’s a shortcut to failure. Instead, read the charts, analyze the data, spot the indicators, and plan your moves accordingly.