Moving Average--A Versatile Indicator

A very basic tool that help in forex trading is moving average (MA).

What is moving average?

Every one of you will be aware of calculating average. If you are given 10 numbers, the average of these 10 numbers is sum of all the numbers divided by 10. In same way if you are having a continous set of numbers,average of set will be different from the previous set and we can plot a graph using the average values obtained. This is called moving average

 In case of forex, the numbers you are considering for finding the average may be

• Close price
• Open price
• High price
• Low price
• Median price etc of the candles.

Types of moving average

There are several varieties of moving averages like simple moving average, exponential moving average, weighted moving average etc. Among these simple moving average and exponential moving average are the most commonly used indicators.

Simple moving average (SMA):

In a simple moving average the basic average calculation is done and graph is plotted based on the averages obtained.

Example:

If you are using a 10 SMA applied to close of the candles, in a 1 hour chart the calculation will be done as follows

Sum of Closing price of  10 consecutive 1 hr candle

10

 For the first 10 hours you will get an average which will be the first point in the graph. Then eliminate the first candle from the series and take the value of the 11^th candle. This will give you next point in the graph. Continue the process till the last formed candle and connect all the points you got as average. This is moving average graph.

Exponential moving average (EMA):

When we are giving more weight-age to the current price while calculating the average value we will get exponential moving average.

EMA can be calculated using the following formula:

EMA(current) = ( (Price(current) – EMA(prev) ) x Multiplier) + EMA(prev)

Difference between SMA and EMA:

• EMA is always faster than SMA.
• EMA takes in to account the latest data with more importance when compared to SMA
• EMA is noisier than SMA

How to apply moving average to chart:

See the above picture. It is a screen short of mt4 platform. Almost every broker provides moving average in their default indicator list. See the right hand side of the image. The section navigator (highlighted in red rectangle) will have all the default indicators. From there you can select moving average and drag to the chart. Otherwise see the top right hand side of the image. There the icon f+ (highlighted in red) will also have indicators. You can select moving average from there.

 Once you select the indicator a dialogue box will appear, where you will be able to select which moving average you need (SMA, EMA, Smoothed, weighted etc.). There are options for selecting the colour of graph for each moving average you are applying to the chart. (very helpful while using multiple moving averages.)

Uses of moving average:

Let’s take a look at how we can use moving averages.

Trend identification

The most important use of moving average is to identify the trend. Moving averages will help you to have a clear idea whether the price is in uptrend, down trend or ranging.

See the above chart the red line is the moving average. The MA is pointing down wards, which indicate that trend is down.

This shows an uptrend.

Helps in reducing the noise.

A raw candlestick chart may sometimes confuse you. Due to the candles with its highs and lows you may not be clear what the price is actually doing. Introducing an MA to the chart will reduce the noise made by the highs and lows of the candles and show you the clear path of price. See the difference between a chart without MA and chart with MA.

chart without MA

chart with MA

Finding dynamic support andresistance points.

Another major use of moving average.MA act as a dynamic support and resistance area.

 See the chart above the red line is SMA 60. The yellow encircled portions clearly shows that MA is acting as a resistance. Whenever price moves up it gets blocked when touches the MA line and go downwards.

This one aspect of MA is very useful in forex trading strategies.

Problems with moving average.

Even though MA is highly beneficial in trading there are some major disadvantages for the indicator.

Delay:

Yes MA is a delayed indicator. Most of the times MA will show a change in direction only after 40% of move has occurred. So if you are a trend trader by the time you take trade by looking at the direction change of MA the new trend would have completed half part of its journey.

Price ranging:

Another serious problem with MA is that it will give false signals when the price is ranging. By the time you have realised that price is not going up or down but it’s ranging, you may have initiated your trade.

Price in Range

Precaution

The major precaution to be used while trading forex with MA is that never use MA as the only indicator for deciding your entry and exit.