Understanding Moving averages

Moving averages are computed by taking an average of the exchange rate for a particular period of time and then allowing it to evolve or move forward over time.

Figure 1: A daily bar chart for the EUR/USD currency pair with a 10 day simple moving average drawn in red and a 20 day simple moving average drawn in blue and superimposed over the price action. The vertical axis is the pair’s exchange rate and the horizontal axis is time.

Various types of moving averages are used as lagging indicators by technical traders to get a sense of what sort of price levels are more typical for a market, as well as to identify trends and possible reversal situations.

The more popular types of moving averages include the following:

  • Simple moving averages
  • Exponential moving averages
  • Weighted moving averages

Computing Simple Moving Averages

To calculate a simple moving average, you would take the sum of closing exchange rates for a currency pair observed over a period of time, and then divide that sum by the number of observations made.

You would then evolve or move the average over time by keeping the number of days observed constant while adding a new one and dropping the oldest one.

For example, for a 20 day simple moving average, you would take the sum of the last 20 days of closing exchange rates and divide by 20 to obtain the value of the simple moving average for that day.

Weighted Moving Averages

Various forms of weighted moving averages are used to help correct this indicator for its general lagging nature and make it more response to recent price action. Such moving averages will generally be computed by giving greater weight to more recent exchange rates in the analysis.

A particularly popular type of weighted moving average is the Exponential Moving Average or EMA in which each successive value increases in significance.

Characteristics of Moving Averages

Some of the general characteristics of moving average include:

  • Averages taken over longer time periods are less sensitive to price.
  • Shorter moving averages tend to have more false signals.

Accordingly, when trading a sideways market, it can give better results to use longer time periods for moving averages to avoid being whipsawed by false trading signals.

Using Moving Averages

Moving averages are generally used in conjunction with confirmation obtained from other technical indicators to avoid false signals.

Some technical traders look for crossovers among short and long term moving averages to signal a trade entry point. They would generally go long when the short term average moves above the long term average and short when the short term average shifts below the long term average.

When using multiple moving averages, traders might also look for tight formations among the averages and price action to signal a coming major move. When the move comes, they would then sell under declining averages and buy above rising averages.

A set of averages can also indicate a coming trend by starting to diverge or spread out. They might also signal a pending trend reversal if they diverge by roughly equal amounts in an already trending market.

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