Moving Averages (SMA, EMA, WMA) - Technical Indicators -ForexAbode.com
Moving Averages for Technical Analysis in Forex Trading:
Here we shall cover the following:
What is Moving Average?
What do Moving Averages tell us?
How to use Moving Averages in Forex trading decisions?
What kind of moving Averages are there?
What is Moving Average:
In Forex Market the currency prices change continuously. A drop in price may not necessarily indicate a downtrend. And also the price going up at another instance may not necessarily mean that currency pair is going bullish or it’s an uptrend.
We need to smoothen out these continuous noises of market i.e. these continuous up and down movement to get the real picture to place our Forex trade.
Moving average for the selected period of time is the average price of the currency pair during that period. Say we use moving average for period 10 on a daily chart. So a simple moving average of 10 periods is going to give us the average price of that currency pair over the last 10 days. As during any particular trading day the price movement can be substantial, we can consider the closing prices of the trading days for calculating the average price. With each new day, it adds that day’s price to the data and drops off the oldest day’s data to calculate the new average. The moving average is a smoothed line that connects all of these averaging points together and gives us the moving average line.
There are various types of Moving Averages and we shall be talking about those towards the end. Please note that before we talk about different kinds of moving averages, we shall be using SMA (Simple Moving Average) as example in the charts and examples below.
Moving averages are among the most popular and widely used technical indicators in Forex Trading/currency trading. Moving averages can help us in avoiding the confusion about the actual trend when market takes some small corrective actions (by small corrective actions we mean a small amount of retracement in the opposite direction of the ongoing price movement or the current market trend for the concerned currency pair) With moving averages we can visualize and measure a trend in Forex trading. Like most indicators in technical analysis, moving average is a trend following/lagging indicator. Trend following or lagging indicator means that it does not predict in advance about the future direction for the price but it confirms the trends once they have begun.
What do Moving Averages tell us for our Forex Trading decisions:
1) Identify or confirm the trend in Forex market.
2) Tell us about the reversal points of the trends i.e. when a trend is reversing from uptrend to downtrend or vice-versa or from a trend to sideways market or vice-versa.
3) They also tell us about the momentum of the market or the strength of the trend for the currency pair.
4) Moving averages also help us in showing the support and resistance levels for the prices of the concerned currency pair.
1) Identification or confirmation of a trend by Moving Averages in Forex trading:
We can use Moving Averages for confirmation of a trend. For example, when the prices (closing prices) are continuously above the moving average line and the moving average line is in sloping upwards, it confirms that the market is bullish or is in an uptrend. Here we can enter the long (buy) positions for the concerned currency pair. Similarly when the prices (closing prices) are continuously below the moving average line and the moving average line is in sloping downwards, it confirms that the market is bearish or is in a downtrend. Here we can enter the short (sell) positions.
Identifying/confirming the trend is shown in the EUR/USD Forex chart below:
If you look at the forex chart for EUR/USD above (Fig 2), you will see that during the downtrend indicated by the red arrow on the left hand side, the SMA line is sloping downwards. Also the closing prices for periods marked by red and green bars of the candle stick chart are most of the time staying below the SMA line. This is confirming a downtrend between point A and point B. After point B an uptrend is starting. This is being confirmed by the SMA line sloping upwards and most of the times the closing prices remaining above the SMA line.
Please note that each bar of the candle stick chart shows us the movement of price during the selected period. If we are using an hourly forex chart then each bar shows us the price movement during that one hour. If we are using daily forex chart then each bar of candle stick chart shows the price movement during that one day. Green bars means upward movement of price during that period i.e. prices opened low, went up and the closing price was more than the opening price. The red bar shows that during that period the prices went down i.e. opening price was high but then the price went down and closed at lower level than the opening price.
Moving Averages as Support and Resistance Levels in Technical Analysis:
We can also use Moving Averages to know the support and resistance levels in Forex (currency) Trading. When the prices hit the moving average line, they often stop and reverse. You will notice that during an uptrend when the price go downwards and reach near the SMA line, or touch it or cross it a bit, the price jumps again and move up. Similarly during a downtrend when the price go upwards and reach near the SMA line, or touch it or cross it, the price reverse and move down again. Please see the Fig 1 above (the first figure in this section) for a better visual understanding.
Moving Averages - Signal for Reversal of Trend:
When the moving average suddenly goes lower than the previous period, it may be a signal that the ongoing uptrend may be ending.
Similarly when the moving average suddenly goes higher than the previous period, it may mean that the downtrend is ending.
Please see the Forex chart for EUR/USD in Fig 4 below:
1) The left most part of the currency chart is showing an uptrend. The peak of this uptrend was at “Peak 1”. Our bought position would have given us the maximum profit if we could close the position at peak 1. But it is practically impossible to buy at the lowest price and sell when the prices are at the top. We can never know that the currency pair prices would not go up further and would rather start going down (reversal of the trend). We need to wait to see that the uptrend is really ended and a downtrend has started.
Now compare points “A” & “B” on the SMA line on this daily forex chart of EUR/USD. Till point “A” the SMA line is sloping upwards. During the next period (day in this case as this is daily chart) the point “B” on SMA line is lower than the point “A”. That means the SAM on the next day is lower than the SMA of the previous day. This signals that it MAY be the beginning of a downtrend and it is better to close the bought position. In fact this proved to be a true signal as uptrend reversed and the downtrend continued after point “B”
2) Points “C” & “D”: Similar to the example above in point (1), Peak 2 was the lowest price in the downtrend. We would wait till we see that the SMA has gone up than the previous day because this would be the signal that the down trend may be over and an uptrend may start. SMA at point D is more than SMA at point C and it is the signal that we should close our position (Short sold position during this downtrend). It was also not a false signal as the downtrend really ended and an uptrend started.
3) Points “E” & “F”: SMA at point “F” went down a bit than SMA at point E on a SMA line which was sloping up (uptrend). This signaled a reversal of uptrend and indicated that a downtrend may be starting. In one way it could be seen as a false signal as after a little drop the uptrend resumed again. But if we really see, the signal for downtrend (point F lower than point E) was on April 4th and the uptrend resumed around April 17th. So, in case we would not have come out of our trade, we would have had almost 2 weeks running into negative with our money stuck up and not usable for entering any other position.
Other ways of to using Moving Averages in technical analysis for Forex trading:
1) Comparing Moving Averages with actual prices directly
2) Comparing two or more Moving Averages of different time period for example Moving Averages for period 10* and Moving Averages for period 20*.
(*Period: Period 10 means a moving average for past 10 days on any given day on “daily chart” and on hourly chart moving average for past 10 hours on any given hour.)
Both of these ways work on crossover studies. By Crossover study we mean when a line is crossing the other line.
The closing price of the currency pair for a period moving above the moving average can be interpreted as a buy signal. Similarly the closing price moving below the moving average can be interpreted as a sell signal. This is known as the crossover rule. This is explained earlier in this document under the head “Identifying or confirming a trend”. The confirmation of this signal is when the moving average line is also moving in the direction of prices. Please see Fig 2 and Fig 4 in the beginning of this write-up.
If we use Moving Average of short period (5 period or 10 period) the prices will tend to be closer to the Moving Average line. Moving average of shorter periods will give more number of signals than the moving average for longer term (say 20 period or 50 period. The point to be considered that many of those signals may prove to be false.
Please also note that the signals from longer term moving averages work better while when the market is in trend (uptrend or downtrend). When there is a reversal of trend a shorter term Moving Average would work better (during the reversal process and before the next trend).
To avoid false signals, you may let the Moving Averages confirm it by waiting for some extended time and not taking a trading decision as soon as the crossover takes place.
Double Crossover – Using Two Moving Averages:
Let’s say that the moving average for past 10 days is 150 and the moving average of past 20 days is 100. What does it imply? It implies that the prices during the past 10 days have been going up or in the other words the currency pair is becoming bullish (uptrend or a stronger uptrend than before). This gives a “buy” signal for the concerned currrency pair. Similarly if the shorter term Moving Average is going below the longer term Moving Average line, this may be a signal that the currency pair is going to fall and a downtrend may start. This can be taken as a “sell” signal.
The momentum of the price movement can be measured by using multiple moving averages of different time periods. We can use two or more moving averages with different time period e.g. Moving Average for period 10* and period 20*and look at the divergence i.e. which one is going up or down.
*Period: Period 10 means a moving average for past 10 days on any given day on “daily chart” and on hourly chart, moving average for past 10 hours on any given hour
As per the example in the first paragraph, during an uptrend, if the shorter term moving averages, let’s say SMA for 10 period, is more than the longer term averages, let’s say SMA for 20 period - it confirms that the uptrend is gaining momentum. Please check Fig 6 below.
The green line if for Moving Averages for Period 10 and the red line is for Moving Averages for period 20. At point “A” the moving average line for period 10 has crossed the line for Moving Average for the period 20 and moved up. This gave a “buy” signal that the prices may get an uptrend. This proved to be correct as there was a rally in the prices and prices shot upwards.
Similarly at point B the Moving Average line for period 10 has crossed the line for Moving Average for the period 20 and went below. This gave a “sell” signal that a downtrend might start and price might go down. This proved to be correct as the downtrend really started.
The Triple Crossover Method:
As the name suggests, here we use three Moving Averages for different time periods. This method provides fewer but more surer signals. While we say surer signals, we also compromise on the fact that the signal may come little late.
In the above Forex chart we have used three moving averages. Moving average for period 4 (green line), moving average for period 9 (white line) and moving average for period 18 (red line). In this method we get the surer signal when the moving average line for the shortest period crosses both the other moving average lines.
At point “A” the moving average (4) crossed the moving average (9) and gone below.. This could be a signal that the downtrend may start and we could go for a short selling position. But we waited till point “B” when the moving average (4) also crossed the moving average (18) and wend below it. Here we entered the short position (at point B).
Similarly we waited to enter a long (buy) position at point “X” when moving average (4) crossed the moving average (9) and went above it. We waited till point “Y” when moving average (4) also crossed the moving average (18). This increased the probability of the signal being true.
Types of Moving Averages in Technical Analysis in Forex Trading:
1) Simple Moving Average (SMA)
The Simple Moving Averages uses the arithmetic mean of a given set of values i.e. in technical analysis the prices for a given period. If we use SMA of period 10 on a daily currency chart that would mean closing prices for each day for past 10 days. The average is 'moving' as when new data comes in the oldest data would be replaced by the new value.
The drawback of Simple Moving Average is that it gives equal weight to old data as well as most recent data. Some technical analyst feel that more recent data should have more weight.
2) Linearly Weighted Moving Average (WMA)
The linearly weighted moving average gives more weight to more recent data (prices). For example, using a day 10 moving average the 10th day would be multiplied by 10, the 9th day by 9 and so on. This makes WMA more sensitive to the more recent price movement.
3) Exponentially Smoothed Moving Average (EMA)
In technical analysis the EMA is more popular that SMA and WMA. Let’s see how EMA is different from Linearly Weighted Moving Average.
"Linear growth" means that the original value increases periodically by a set amount. "Exponential growth" means that the original value increases periodically by a set percentage.
For a visual explanation please see the figures 8 below.
So unlike Linearly Weighted Moving Average, in which the weight is reduced linearly for older data, in EMA the weight is reduced exponentially i.e. more recent data has much more weight and older data has much reduced weight.
We explained Moving Averages (SAM, EMA and WMA) in the context of Forex Trading but the same stands good for stock trading or any commodity trading.
