Moving Averages

Moving Average is one of the most common ways to standardize and represent data without the noise. The first technical Analysis tool that we all learn about when we start trading is Moving Average. In this article I will talk about how moving averages work and which one we must have on your charts.

A moving average is simply a way to smooth out price action over time. By ‘moving average’ I mean that you are taking the average closing price of a currency pair for the last ‘x’ number of periods. Like every indicator, a moving average is used to help us forecast future prices. By looking at the slope of moving average, you can better determine the potential direction of market prices.

As I stated earlier, moving averages smooth’s price action. There are different types of moving averages and each of them has their own level of smoothness. Generally, smoother the moving average, the slower it is to react to the price movement. The choppier the moving average, the quicker it is to react to the price movement. To make a moving average smother, you should get the average closing prices over a longer time period.

Moving Average can be classified in two major categories i.e. Simple and Exponential. A Simple moving average is calculated by adding up the last ‘x’ period closing prices and then dividing that number by x.The SMA gives the overall sentiments of the market. With the use of SMA’s you can tell whether a pair is trending up or down or just ranging.

There is one problem with Simple Moving Average and it’s that they are susceptible to spikes. When this happens they can give you false signals. You might think that a new trend is developing but in reality nothing changes.

Exponential moving average is similar to simple moving average except that more weight is given to the latest data. It is also known as exponentially weighted moving average. This type of moving average reacts faster to recent price changes then a simple moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go.

The benefits ofusing SMA is that it displays a smooth chart which eliminates most fake outs while the disadvantage is that is slow moving, which may cause a lag in buying and selling signals. On the other hand EMA is quick moving and is good at showing recent price swings while it is more prone to cause fake outs and give errant signals.