Mastering Moving Averages for the Day Trader
What is a Moving Average
A moving average is a calculation performed on data arranged in a time sequence. It is used to help make it easier to visualize trends underlying the raw data. The concept is very straightforward. Data is presented in increments of a particular time period, usually for our purposes in daily intervals but it can be in intervals as small as one minute. Some particular number of data points is averaged and the value placed on the graph at the point of the most recent measurement. For the next increment, the oldest measurement is dropped and the most recent added and the average calculated again. The line generated by these calculations is superimposed over the data and each point represents the average of the proceeding measurements found in a moving time period window. The result is a line which is considerably less choppy and volatile than the underlying data, and the smoothness of the line increases as the number of periods in the window increases. In a graph with daily increments, a 5 day moving average will follow the raw data pretty closely, while a 50-day moving average boils the volatile time series down to a very smooth long-term trend. While most moving average plots used by currency traders are calculated on daily data, it’s also possible to plot a moving average for intra-day data.
5 and 50 Day Simple Moving Average
The Moving Averages
The basic moving average describe above is called a “simple moving average.” All data points in the time window are given equivalent weight. This is one of the two types of moving averages most commonly used by forex traders. The second type is called the “exponential moving average.” This moving average is calculated in the same way as the simple moving average except the more recent data points are treated mathematically so they have a stronger effect on the resulting line. (An exponential moving average is a particular case of a “weighted moving average”) As exponential moving average will react more quickly to abrupt changes, particularly changes which are inflection points between bull and bear trends as we can see in the price chart below. The red line which is 5 period exponential moving average is far more sensitive to price changes than the blue line which represents a 50 period simple moving average.
Simple and Exponential Moving Average
Books on Moving Averages
The Moving Average as a Technical Analysis Indicator
If all a trader could discern from moving averages was a visualization of longer term trends, it would still be quite valuable, however moving averages have now been incorporated as lagging indicators and honed into a technical analysis technique. There are a couple variations of this technique; what they have in common is that moving averages are used to identify buy signals and sell signals, points at which the market is probably moving from bearish to bullish or vice versa. The standard caveat applies: like all technical analysis indicators, slavishly following this one is likely to give undesirable results sooner or later. The first technique uses daily price data and a single moving average plot. The buy signal occurs when the currency price closes above the moving average, and, conversely closing below the moving average generates a sell signal. The EUR/USD 1 hour price chart below shows this technique using a 10 period moving average. We use a 10 period moving average to have a smoother line and to avoid any false signals. The green circles are buy signals and the red circles sell signals. I have also indicated the point at which you should close out your position. If I have a short position I will square it when the next full green candle appears above the moving average. For a long position I will square the position when the next full red candle appears below the moving average. Just as a point of interest most traders use the simple moving average as there is no evidence that the exponential moving average gains more profits or is more accurate. It can at times also give more false buy or sell signals than a simple moving average.
10 Period Simple Moving Average
The Moving Average Concept
Did you understand the explanation of the use of moving averages?
Two and Three Simple Moving Averages
The second analysis technique uses two or three moving averages, one with a longer period than the other one or the other two. The theory behind the use of two moving averages is that when the fast moving average (usually a 5 period moving average) crosses the slower moving average (usually a 10 period moving average) a buy or sell signal is generated. A buy (bullish) signal is generated when the fast moving average crosses the slower moving average from below (the golden cross). On the other hand when the faster moving average crosses the slower moving average from above (the dead cross) a sell (bearish) signal is generated.
I personally like using three simple moving averages because I believe that when the fast moving average has crossed both of the slower moving averages I have a stronger buy or sell signal and less likelihood of a false signal. I generally use a 20 period moving average as my 3rd confirmatory moving average line.
Below is a EUR/USD 1 hour chart using three simple moving averages, a 5, 10 and 20 period moving average. It shows several points as indicated by the arrows where the buy and sell signals are located. As you can see over a six day period there were 4 strong sell signals and one strong buy signal. I not only use the 20 period simple moving average as confirmation but also a Relative Strength Index which is in the window below the chart. The RSI is a further key confirmation of the buy and sell signals. Below the chart is a brief introductory explanation of how it works.
EUR/USD 1 Hour Chart
The Relative Strength Index
The Relative Strength Index is a leading indicator and indicates when a currency pair is overbought or oversold. The index runs on a scale of zero to 100 and the way it is used is to consider that if the index crosses the 50 line upwards a buy signal is generated and if the index crosses the 50 line downwards a sell signal is generated. Many traders wait until the RSI enters the overbought (the line is above 70) area (sell signal) and the oversold (the index is below 30) area (buy signal) before entering a trade.
If you look at the RSI below the EUR/USD chart you will notice that the RSI confirms the buy and sell singles of the moving averages when the index crosses above the 50 or crosses below the 50 line.
Moving Average Quiz
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Mastering the Technique of Moving Averages
As you can probably guess, this technique, while simple enough to grasp in broad outline, requires experience and instruction before it can reliably used in your trading decisions. There’s of course a wealth of information and guidelines available on mastering moving averages in foreign currency trading in many books on technical analysis and in courses on currency trading. I have selected a few of the more reliable books on this subject for your reading pleasure on both Amazon or on eBay. However, you can also master the technique by following the explanations and graphics laid out in this article. In addition I am considering holding a live webinar on the topic some time soon. Perhaps those of you who are interested could let me know through the comments section.