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.

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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.

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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.

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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.

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