Moving averages (MA) are a popular technical tool in the forex market, traders use them usually as a tool to enhance their analysis, but moving averages can also be used to support the decision making a process for investments.
Although some traders use moving averages to identify potential support and resistance levels, this technical indicator can also be used to identify trends in various stages of their development.
How Can You Benefit from Moving Averages?
The obvious benefit of using moving averages is their ability to significantly reduce market noise. Short-term price fluctuations tend to be very chaotic, and moving averages do a fantastic job of smoothing any unnecessary market noise out. This makes it easier to identify new market trends in their early stages.
The most common settings for moving averages are the following: the 50-day MA, the 100-day MA, and the 200-day MA. These MAs are considered as major support and resistance levels and are closely followed by a lot of traders (and big players) around the world.
Types of Moving Averages
There are three main types of moving averages:
- Simple Moving Average
- Exponential Moving Average (EMA)
- Weighted Moving Average (WMA)
Now, let’s look at each of these in greater detail.
Simple Moving Average (SMA)
This is the first and most basic type of MAs. It’s calculated by summing up the closing prices of a number of periods, and the result is then divided by the same number of periods. For example, if you plot a 10-periods simple moving average on a 30-minutes chart, the calculation would sum up the closing prices of the last 10 bars, and divide the result by 10 in order to get an average.
Exponential Moving Average (EMA)
EMAs are similar to simple moving averages, with the main difference that they give more weight to more recent periods, and less weight to older periods in the series. Exponential moving averages perform well in trending markets.
Weighted Moving Average (WMA)
WMAs are very similar to EMAs, as they also give greater importance to more recent periods. The main difference between WMAs and EMAs is the way they’re calculated. WMAs can have different weights assigned for different numbers of periods.
The following chart compares each type of moving averages and shows how the difference in calculation reflects on the chart. As you can see, the exponential moving average is usually the first to change its direction with the price change, followed by the weighted moving average, and in the end the simple moving average.
Moving Average Crossover Strategies
Understanding how an indicator works and how it is calculated is important in order to build a strategy around it. Without knowing the nature of a moving average, you can’t tweak it to get the best possible results in trading, such as determining the right period-settings for the crossover strategy.
The crossover strategy is one of the most basic forex strategies out there, which can be either a “price crossover” or an “MA crossover”.
The Price Crossover – Simply said, when the price crosses below or above a moving average, it creates a sell or buy signal, respectively. Crossovers are also used to reflect shifts in momentum, as they remove emotions in trading by creating clear, unbiased signals. The following chart shows two price crossover trades. The buy is triggered when the price crosses above the 30-period EMA and the sell is triggered when the price crosses below the 30-period EMA.
This strategy is also notorious for creating many false signals, as shown in the beginning of the chart. That’s why you always need another confirming signal before entering the trade, such as the second candlestick closing above the MA, or a strong bullish/bearish candlestick pattern.
The MA Crossover – This strategy is based on two moving averages with different period settings. One moving average is the short-term MA, and the second moving average is the long-term MA. The trade is triggered when the short-term MA crosses above or below the long-term MA, creating a buy and sell signal, respectively. Common settings for the short-term and long-term MAs are 10 periods and 50 periods.
The following chart shows a buy and sell signal based on MA crossovers. The buy is triggered with the 10-periods EMA (red) crossing above the long-term EMA (yellow). Similarly, the sell is triggered with the short-term EMA crossing below the long-term EMA.
When to Use SMAs, EMAs, and WMAs
While the SMA is a simple average of prices for a given period of time, EMA gives more weight to recent periods. In trending markets, exponential moving averages will give better results, as they’re able to early catch a new trend or a trend reversal. They’re also used as entry signals and are not as lagging as simple moving averages. Standard settings for an EMA include a 12-26 period, usually on a daily timeframe. Still, simple moving averages are very popular as they are easy to use and calculate.
When to use each type of moving averages also depends on your objective. If you just want to reduce market noise in order to get a better sense of where the market is heading, simple moving averages will do the job. But, if you want to put more weight on the most recent price changes, weighted and exponential MAs are the better choice. Nevertheless, weighted and exponential MAs tend to be more volatile due to the increased importance of recent price action.
Cancel out the Market Noise
Moving averages are a simple, yet very popular technical tool among traders. As their name suggests, moving averages simply aim to “average out” the price and are often used to cancel out the market noise, identify shifts in momentum in their early stage, or as part of MA crossover strategies. Take note that exponential and weighted moving averages give more importance to the most recent closing prices, compared to simple moving averages which distribute equal weights across all periods. Therefore, EMAs and WMAs can become more volatile in case of large price fluctuations in recent periods.