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Forex Analysis |
Daily Technical Analysis
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Moving Averages | Chart Indicators | ForexAbode Forex School
Last Updated (Wednesday, 04 January 2012 12:13) GMT
Moving Averages:
Moving averages are used very commonly in technical analysis for the identification and confirmation of trends and also to indicate the entry and exit points by crossovers of moving averages of different time periods. This indicator is also used for the indication of support and resistance levels among other uses. Let's see how to use this popular technical indicator for forex trading decisions and building trading strategies. Please note that the explanations are focused for Forex trading but this a valid for stocks or any other commodity trading.
Here we shall cover the following:
In trading markets the prices change continuously. A drop in price may not necessarily indicate a downtrend. And also an upward jump 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 movements to get the real picture to place our trade.
Moving average for the selected period of time is the average price during that period. Say we are analyzing daily chart then the simple moving average of 10 periods is going to give us the average of the last 10 days. As during any particular trading day the movement can be substantial, we can consider the closing prices of the trading days for calculating the average. 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 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 types, we shall be using SMA (Simple Moving Average) as example in the charts and examples below. We also have the explanation about other types of averages e.g. EMA (exponential) and WMA (weighted).
Chart 1:
Moving averages are among the most popular and widely used technical analysis indicators. These 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 movement or the current market trend). With moving averages we can visualize and measure a market trends. Like most indicators in technical analysis, this is a trend following/lagging indicator. Trend following or lagging indicator means that it does not predict in advance about the future direction but it confirms the trends once they have begun.
1) Identify or confirm the trend.
2) 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) Momentum of the market or the strength of the trend.
4) Support and resistance levels.
We can use Moving Averages for confirmation of a trend. For example, when the closing is continuously above the moving average line and the 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. Similarly when the closing is continuously below the moving average line and the 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 Forex chart below:
Chart 2:
If you look at the 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 for periods marked by red and green bars of the candle stick chart are most of the time staying below the simple moving average 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 remaining above the SMA line.
We can also use Moving Averages to know the support and resistance levels. When the prices hit the moving average line, they often stop and reverse. You will notice that during an uptrend when there is a downward move and it reaches near the moving average line, or touch it or cross it a bit, there is a jump again and move up. Similarly during a downtrend when there is an upward correction towards the SMA line there may be a reversal and a downward move again. Please see the chart 1 above for a better visual understanding.
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 below:
Chart 3:
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Please check adjacent points “A” & “B”, “C” & “D” and “E” & “F”.
1) The left most part of the 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 level and sell at the top. We can never know that there will not be further upward move. 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 chart of EUR/USD. Till point “A” the SMA (simple moving average) 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 point 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. Moving average 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.
1) Comparing Moving Averages with actual prices directly
2) Comparing two or more Moving Averages of different time period for example MA for period 5* and MA for period 22*.
(*Period: Period 5 means the average for past 5 days on any given day on “daily forex chart” and on hourly chart for past 5 hours on any given hour.)
Both of these ways work on crossover studies of the moving averages of different time periods. By Crossover study we mean when a line is crossing the other line.
Crossover:
The closing for a period going above the moving average line can be interpreted as a buy signal. Similarly the closing price going below the line 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 price action. Please refer the charts in the beginning of this write-up.
If we use Moving Average of short period (5 periods or 10 periods) the prices will tend to be closer to the MA line. Moving average of shorter periods will give more number of signals than the longer term averages (say 22 period or 55 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 then the a shorter term time-frame 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.
Let’s say that the moving average for past 5 days (trading week) is 150 and that of past 22 days (trading month) is 100. What does it imply? It implies that the prices during the past 5 days have been going up or in the other words the pair is becoming bullish (uptrend or a stronger uptrend than before). This gives a “buy” signal for the concerned currency pair. Similarly if the shorter term Moving Average is going below the longer term MA line, this may be a signal that there may be a fall and a downtrend may start. This can be taken as a “sell” signal.
Please note that the crossover signals are not only for SMA but for EMA and WMA also, which are explained in other chapters (please find the links at the bottom).
The momentum of the 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. for period 5* and period 22* and look at the divergence i.e. which one is going up or down.
*Period: Period 5 means past 5 days on any given day on “daily chart” and on hourly chart, for past 5 hours on any given hour
As per the example in the first paragraph, during an uptrend, if the shorter term moving averages, let’s for 5 period, is more than the longer term average, let’s say for 22 period - it confirms that the uptrend is gaining momentum. Please check Forex chart 4 below:
Chart 4:
The green line is for Moving Averages for Period 10 and the red line is for period 20. At point “A” the line for period 10 has crossed the line for the period 20 and moved up. This gave a “buy” signal that there may be an upward movement. This proved to be correct as there was a rally and a jump upwards.
Similarly at point B the Moving Average line for period 10 has crossed the line for the period 20 and went below. This gave a “sell” signal that a downtrend might start. This proved to be correct as the downtrend really started.
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.
Please see Forex chart 5 below for a visual explanation.
Chart 5:
In the above forex chart we have used three moving averages. One for period 4 (green line), second for period 9 (white line) and third for period 18 (red line). In this method we get the surer signal when the line for the shortest period crosses both the other moving average lines.
At point “A” the moving average (4) crossed the line for period 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 this line i.e for period 4 also crossed the moving average for period 18 and wend below it. Here we entered the short position (at point B).
Similarly we did not enter a long (buy) position at point “X” when moving average for period 4 crossed the line for period 9 and went above it. We waited till point “Y” when this line ( period 4) also crossed the line for period 18. This increased the probability of the signal being true.
In the above example we used the periods 4, 9 and 18 but that is just to explain the concept and not a standard strategy. In different kinds of market movements and volatility situations we need to work out with different combinations. One of our favorite combinations is to use period 5, 22 and 55.
We have detailed explanations of different types of separate pages but the overview of different moving averages for technical analysis is as follows:
The Simple Moving Average (SMA) uses the arithmetic mean of a given set of values. If we use SMA of period 10 on a daily 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 SMA 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 (WMA) gives more weight to more recent data. 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.
Read about Weighted Moving Average
In technical analysis the EMA is more popular that SMA and WMA.
Let’s see how EMA is different from WMA:
"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.
Read about Exponential Moving Average.
For a visual explanation please see the figures below.
So unlike Linearly WMA, 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 as technical analysis indicators in the context of "Forex Trading" but the same stands good for stock trading or any commodity trading.
You may also check Moving Average Convergence/Divergence). |
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