Different Types of Moving Average: Chart Example and Tips

What is a Moving Average?

A moving average (MA) is a trend-following indicator, which means that it turns after the trend has reversed. It shows the average value of prices in its time window, which you specify. A 20-day MA shows the average price for the past 20 days, a 100-day MA shows the average price for the past 100 days.

Types of Moving Averages

There are three main types of MA, namely, the simple moving average (SMA), the exponential moving average (EMA) and the weighted moving average (WMA). SMA gives equal weighting to each piece of data. That would be each day for a daily chart, each week for weekly charts, and so forth. EMA, on the other hand, gives greater weight to the more recent data, thus making the average more sensitive to price changes. A weighted moving average allows you to assign any weight to any day, depending on what you deem important.

A lot of traders prefer to use EMA since it responds to changes faster than an SMA, and does not drop old data as abruptly as an SMA does. I prefer to use both SMA and EMA on my charts since some studies have shown that using an EMA is not more advantageous than an SMA when it comes to actual trading.

The choice of time span is important when using the moving average technique. For example, it doesn't make sense to use a 100-day moving average to monitor a short-term trade since the average will be so smoothed out that you won't get any signal. On the other hand, if you use a 5-day moving average to monitor a long-term trade, you will end up with too much noise with the countless whipsaws.

How to Use Moving Averages in Forex Charts

Trend Identification

Note the direction of the slope of a moving average. If it is rising, it indicates an uptrend. If it is falling, it indicates a downtrend. When the MA is flat, it means that the market is sideways.

Dynamic Support and Resistance

Moving averages act as flexible support and resistance areas. Depending on the market sentiment, it pays to buy near a rising MA, and short-sell near a falling MA.

Crossover

When the market is bullish than before, prices rise above / cross over a moving average. When the market is more bearish than before, prices fall below / cross over a moving average. Use MA crossover together with a price pattern completion or a trendline violation for better results.

Real Chart Example 

Figure 1

Figure 1 above shows an hourly EUR/USD candlestick chart with a 22-day exponential moving average.

As you can see, a declining MA indicates a downtrend whereas a rising MA indicates an uptrend. The first red arrow shows that the currency price has broken above the EMA, but not above the down trendline. If you had just bought above the EMA crossover, the trade would have gone against you as the price quickly melted down from the trendline resistance as reflected in the bearish candle with a long top arrow. If market sentiment supported a weaker EUR against USD, the trendline resistance point would have been a good place to short-sell.

A great opportunity to buy EUR/USD is indicated by the blue arrow, when the EMA crossover (circled) had already been preceded by the trendline break, confirming a bullish reversal signal. Next, EUR/USD saw a period of an uptrend, as evidenced by both the up trendline and the rising EMA, moving closely in tandem. It would have been a good place to buy EUR/USD when the price approached the EMA and trendline support. The trend reversal, as indicated by the second red arrow, happened when the price first crossed below the EMA, then broke below the up trendline.

Trading Tips for Moving Averages

·       In Forex trading, having multiple confirmations for trend reversal results in a much higher probability of trade than just trading MA crossovers in general.

·       Keep in mind that the steeper the ascent or descent of the MA, the more likely the crossover will turn out to be a whipsaw.

In a trading range, a moving average is almost flat, and so MA crossovers are almost always false. MAs work better in trending conditions.