Guess what we’re doing today? We’re moving averages. Today we’re starting the first of a two part series how to trade moving averages using price action analysis.
Moving averages action indicator is very popular among traders as it helps them forecast future price moves – Almost like forecasting the weather. We’re going to find out what moving averages really are, and various ways to use them. But first things first:
What In The World Is a Moving Average?
Well, a moving average is a technical indicator that calculates the price or exchange rate of a currency pair. You’re basically striking an average closing price of a currency pair over a fixed number of periods. Let’s take a look at a typical moving average.
This is what a moving average looks like. The slope helps us determine the future direction of prices. It is must be noted that there are different types of moving averages and each of them has their own smoothness level. The smoother the moving average, the slower its reaction time to the price movement. But if the moving average gets more choppy, its reaction time is much quicker.(I used to think it was the other round..But then What did I know?). So if you want a smoother moving average, strike your average over a longer time period.
Now there are two types of moving averages that traders use – Simple Moving Average(SMA)and Exponential Moving Average(SMA). We’ll take a look at both averages individually , and then identify similarities and differences-if there are any. For the sake of simplicity, we’ll use their acronyms, SMA and EMA.
But first let’s start with:
Simple Moving Average
Well,at the risk of repeating myself, simple moving average is the simplest type of moving average you can use in forex analysis. Simple Moving Average(SMA) is simply the calculated average of price over specific time periods. Basically you calculate an SMA by calculating the prices of one period and then divide it by that period. Scratching your hair already? Not to worry,let me break it down for you
Say you plot a 5 period SMA, on a one hour chart,you add up the closing prices of the last 5 hours and then divide that number by 5.
If you plot a 5 period SMA on a 10 minute chart,you add up the closing prices of the last 50 minutes and divide it by 5.
If you plot a 5 period simple moving average on a 30 minute chart, you add up the closing prices of the last 150 minutes and then divide it number by 5.
I hope you get the picture. If not you let me know.
Now let’s see how moving averages put their smoothness level on the price action
In case you haven’t noticed three SMA’s can be seen on th USD/CHF’s 1 hour chart. The longer the SMA period,is the more the price pulls away from the SMA period. That seems to be the case with the 62 SMA ait is staying adrift from the price than the 30 and 5 SMA’s.
Now why is that so? This is because the 62 SMA adds all the prices of the last 62 periods and divides the sum by 62. So the longer the period,the slower the reaction time of the SMA to the price movement.However,there is one problem with the SMA that you should be aware of.And that is, it’s vulnerable to price increases. And when that happens, you get false signals.
The next moving average solves the false signals.And the name is:
Exponential Moving Average(EMA)
If you read my last post, Something called Confluence, you’d have come across Exponential Moving Average. It was listed as one of the factors to look for when trading points of confluence.The Exponential Moving Average(EMA) is just as popular as the SMA. Unfortunately that is where the similarity ends.Unlike the SMA,which deals with future prices,the EMA deals with prices of the here and now. Plus,it has much quicker reaction time to price events than the SMA. And, like I indicated earlier, the EMA helps solve SMA’s vulnerability to price hikes. Let’s see how EMA solves this problem.
This EUR/USD shows prices calculated by the SMA over a 5 day period:
Day 1: 1.3172
Day 2: 1.3231
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
After gathering these figures, you calculate the SMA as such.
(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209.ffecy,
So far so good. But supposing a significant market event causes the Euro to dip across board.And it causes the Euro to crash and land at 1.3000. Let’s see what effect, if any, this crash will have on the 5 period SMA:
Day 1: 1.3172
Day 2: 1.3000
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
Sure,the SMA looks lower.And it gives the impression that the Euro is going down, when in fact, the Day 2 drop was just a drop in the ocean.
This when EMA comes in. Unlike, SMA which only focuses on 1 and 2,EMA places emphasis on today 3,4,and 5.So that even if the EUR loses value on day 2, the spike wouldn’t make much of a dent on the EUR as EMA would only be focusing on recent price data. In other words, EMA is only concerned about what traders are doing presently as opposed to the future.
Now let’s take look at a 4 hr USD/JPY chart and see how EMA and SMA will look side by side.
See how the red line(EMA) is closer to the blue line(30 SMA)? This is because EMA is a lot more accurate than SMA. Why?Because EMA places more emphasis on current happenings.. The moral of the story is when trading with moving averages, deal with what’s happening here and now rather than what happened last month.
That’s a wrap for”We’re Moving Averages. We’ve identified what moving averages are and two types of moving averages – Simple Moving Average(SMA) and Exponential Moving Average(EMA). Next time we’ll try to complete We Are Moving Averages Part II.
Til next time take care.
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