If you're a novice trader you probably already heard the term ‘moving average’. You saw it in articles, but perhaps you’re not quite sure what it is and what’s its purpose. Or maybe, you are an experienced trader who never dived into the world of technical indicators such as moving averages.
What is it?
Moving averages are among the most widely used and efficient indicators for technical analysis.
What does it do?
It helps to smooth out the price action by filtering out the so-called ‘noise’’ from price fluctuations. Moving averages identify the trend direction and determine support and resistance levels.
There are four different types of moving averages, some more complex than others. The two most commonly used moving averages are:
SMA- Simple Moving Average
EMA- Exponential Moving Average
The other two types are:
SMMA- Smoothed Moving Average
LWMA- Linear Weighted Moving Average
The formula for each type is different. In fact, it's the calculation that diverges all four considerably from each other. SMA is the simple average of a security over a defined number of time periods, and the EMA gives greater weight to more recent prices. You can learn more about SMA and EMA here.
Moving averages are based on past prices. It either follows the trend, or it lags. The longer the timeframe for the moving average the greater the lag. To put it simply, depending on the timeframe the indicator will be positioned differently on the chart.
How to use moving averages?
The timeframe is an important aspect, namely the length of the moving average depends on the trading objectives. Shorter moving averages are suited for short-term trading and longer term moving averages are more suited for long-term investors. Breaks above and below moving average are considered to be important trading signals. For instance, many traders watch for short-term averages to cross above long-term averages to signal the beginning of an uptrend. Traders identify trading patterns to determine the profitability of a trade. Two popular trading patterns that use Simple Moving Average include the death cross and the golden cross.
The golden cross occurs when a short-term MA breaks above a long-term MA. Reinforced by high trading volumes, it can signal that further gains are in store. Death cross, on the other hand, occurs when the 50-day SMA crossed below the 200-day SMA. This is considered a bearish signal that further losses are in store. It is vital to learn these patterns to recognise certain market behaviours and profit.
Moreover, moving averages also have a huge analytical significance. For example, SMA is used to identify current price trends and the potential for a change in an established trend. It helps to determine quickly if a security is in an uptrend or a downtrend. It can also be used to compare a pair of simple moving averages with each covering a different timeframe.
Knowing the basic of moving averages, you can now start exploring the world of technical analysis which is key to forex trading as one of the pillars of forex analysis which we believe is trifold. Start identifying crossovers and patterns mentioned in the article to recognise the trend of the market and profit.