Moving Averages Explained

Definition of the Moving Average Indicator

The moving average is traditionally a trend indicator. It works by smoothing our price action over a set period of time. There are different ways by which moving averages smooth out price data. The essence of the smoothing function is to reduce the spike fluctuations that occur from one candlestick to another so that the line produced can easily be used to identify emerging trends.

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Moving Average Indicator (exponential)

Several price options can be used by moving averages when smoothing out data. These options can be selected by the trader when editing the parameters on which the moving average will function prior to attaching it to the chart. The price options are:

  • Open
  • Close
  • High
  • Low
  • (Open + High + Low+ Close) /4,
  • ( High + Low+ Close)/3
  • ( High + Low)/2,
  • (Open + Close)/2.

A moving average works to show where the currency pair is headed, as well as strength of the detected trend over a given period of time.

Types of Moving Averages

1. Simple Moving Average (SMA)

The most commonly used moving average, this SMA uses the price point over the time period considered equally on each candle. For instance, if you are considering a 20-period simple average of the closing price, the value will be calculated from the mean of the closing prices of the current candlestick and the previous nineteen candles before it.

The length of the time period will determine the reliability of the moving average as well as the speed of reaction of the indicator to price changes. Longer period MAs are more reliable but react slower to price change. This is why traders tend to use shorter moving averages in volatile markets and longer period MAs in quieter markets.

2. Exponential Moving Averages

The EMA was creates to solve two issues that are commonly seen with the Simple Moving Averages. The equal weighting given to candles by the SMA mean that the SMA changes constantly when new bars appear. The EMA deploys a cumulative method of calculation, meaning that even though all previous bars are considered in calculating the EMA value, older bars lose relevance with time. By focusing on more recent candlesticks, the response time of an EMA to changing trends is faster than the SMA. So EMAs place more weighting on recent candles, making them better at trading short term trends than SMAs.

MAexponentialEBAY

3. Weighted Moving Average (WMA)

Weighted MAs combine the features of Simple and Exponential Moving Averages. The WMA behaves like the SMA in using a fixed time period in its calculations, but behaves like the EMA in placing more weighting on recent candles.

5. Volume Weighted Moving Average (VWMA)

The Volume Weighted Moving Average additionally uses the volume of price movement in assigning weights to the price of each candle. So candlesticks with the heavier volumes will be assigned more weight in calculating the moving average.

Several variations have been made on how the moving averages are drawn on the charts. They can be drawn as variations of the lines or as histograms.

Usage of MA Indicator
Moving averages are basically trend indicators.

Indicator Settings

The indicator is listed on the MT4 in its own category of indicators. To attach it to the MT4 chart, click on Insert -> Indicators -> Trend -> Moving Average.

mov_avg2

In terms of appearance, some modifications to the look of the indicator can be made. These modifications can be either to increase or reduce the line thickness of the individual moving averages or to change their colour to make them distinct from each other, especially when several moving averages are used.

Usage of the Moving Average in Forex Trading

The use of only one moving average in trading is not advocated because of the inherent imperfections in the indicator. The best results are seen when different types of moving averages are used at the same time, or the same types of moving averages with different time periods are used.

1. Combination of two or three moving averages.

A combination of moving averages usually pits a short term moving average (e.g. 9-day MA) against a long term moving average (e.g. 26-day moving average), as seen in the MACD indicator.

We have also illustrated a trading strategy which uses the 50-day EMA and the 110-Day EMA, as well as the use of the 50SMA and 200SMA.

The essence of using multiple moving averages is to be able to recognize the change in a trend much faster than if one moving average were to be used. A cross of a short period moving average over the longer period frame confirms a trend change. Some authorities have also added a triple moving average system to the mix. For instance, the Alligator indicator discovered by Bill Williams combines three moving averages. The extra moving average may now be used to confirm if the market is truly trending or is neutral. So a multiple step confirmation is introduced: the shortest period MA crosses the middle term MA, when both are located above the longest period moving average.

It is also not just about the fact that one MA crosses the other. The angle of cross is also important. Steeper crosses are more reliable than when the crosses are flat.

2. Combination of moving averages with other indicators

An extra indicator can be combined with the moving averages to confirm the cross. For instance, we have described a Moving Average Crossover strategy which uses the coloured MACD histogram as the extra indicator to confirm the moving average cross of two moving average indicators on the main chart. It is also possible to use support and resistance tools such as pivot points to confirm a cross.

For the trade examples, we will refer you to the Modified Moving Average strategy here.

MAcross1

A typical combination of a moving average cross along with the coloured MACD indicator is shown above.

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management. We also ask you to refer to the Forex Strategies section to see how all these MACD signals have been deployed in forex strategies.

Moving Averages


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Video Transcript:

Hello, traders. Welcome to the fifth module of the Advanced Technical Analysis course: Trending Indicators. In this video, we are going to teach you all about moving averages, what they are, and how to use them in your charts. So, let’s start.

What are moving averages? Well, moving averages are trending indicators that are displayed as a line in your chart following price. This line represents the average price of an asset over a specified period of time. If you take for example the 50-period moving average, the indicator will plot the average of the closing price of the last 50 candles, which are periods. And, it will look like this. As you can see here, we are not in a very steep up move but if we plot the 50-period moving average, you can see it as a black line here on your charts.

Now, there is something you need to know about moving averages. You can choose the 50-period moving averages as well, as the 100, 200, and even the one-period moving average. The more periods you use to calculate moving averages, the slower it will react to price. This means that a faster moving average, and when we talk about a faster moving average, we are talking about moving averages that use less periods to calculate the actual indicator are going to react faster to price.

Using moving averages in trading

Now, here is an example of the same chart using the 50-period moving average, which is the black line that you have here, and the blue line here is the nine-period moving average. As you can see, the moving average with the less periods used to calculate it, is reacting faster to price and is following price closer. Now, this doesn’t mean that it is more reliable. In later lessons, we are going to show you how to use different types of moving averages and actually hope to use a two-moving average combination to get signals. But in this lesson, we are just going to teach you what they are and actually, how to plot them and use them.

So, we already saw that the more periods you use to calculate the moving average, the slower it is to react to price. Now, the first use for the moving average are to spot the current trend and its strength. When the moving average points to the upside, we are in a bullish market, just like in this example. Again, this is the 13-period moving average that is following price and as you can see, price is trading above the moving average. And, the angle of the moving average is very steep so we are in a very strong up trend at the moment.

And, when the moving average points to the down side, we are in a bearish market. And of course, the steeper the angle, the stronger the move. And as you can see, price here is trading below the moving average and even if it fakes out a little bit, it continues to dip to the down side. And, the moving average gives you the over-all strength of the move down and the strength of the correction. As you can see, the steepness of the correction is much lesser than the steepness of the move. So, we know that we are not in reversal; we are just correcting before continuing to the downside on a small correction to the upside.

Now, there’s a couple things you need to know. When the moving average is flat we are in a range market, or a range down market, or in a chop, and moving averages don’t work in ranging markets. If we are in a ranging market, we are not going to use moving average in our charts because they will give you too many fake set ups.

Now, the other use for the moving average act as support and resistance. When are in a bull market, we will be looking for support zones to jump into the trend. This is the same example as before. You can see that we are in an up move and then, we correct a little to the down side. Here, we have a red candle stick that rejects the moving average and continues to the upside. And, even if we came back and retested again, the over-all move continues giving us a great entry on a great risk to reward ratio set up right here at this zone, okay?

MA as support and resistance

So, when we are in a bull market, we are going to look for rejections of the moving average as support; and when we are in a bear market, we will look for rejections of the moving average as resistance. In this case, we already said that even though we are already in a down move here, this fake out counts as a correction and of course, we don’t continue to the upside. And, when we press back below the moving average, we have an entry to go short on this asset and as you can see, the risk versus the reward on this trade is amazing.

Now, these sorts of rejections to the moving average can give us entries to get into the move. And remember this, when the moving average is flat, we are in a range or in a chop. If we are in a range or in a chop, we are not going to be using moving average because we are not trending. So, we are not going to be looking for support, or resistance areas, or rejections to the moving averages of support or resistance if we are not trending.

Adam

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