Thinking of trading in a trending environment? Try using moving averages!
What Are Moving Averages?
Moving averages are one most commonly used technical indicators.
A moving average is simply a way to smooth out price fluctuations to help you distinguish between typical market “noise” and actual trend reversals.
By “moving average”, we mean that you are taking the average closing price of a currency pair for the last ‘X’ number of periods. On a chart, it would look like this:
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.
As we said, moving averages smooth out price action.
There are different types of moving averages and each of them has their own level of “smoothness”.
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it is to react to the price movement.
To make a moving average smoother, you should get the average closing prices over a longer time period.
How to Choose the Proper “Length” of a Moving Average
The “length” or the number of reporting periods including the moving average calculation affects how the moving average is displayed on a price chart.
The shorter its “length”, the fewer the data points that are included in the moving average calculation, which means the closer the moving average stays to the current price.
This reduces its usefulness and may offer less insight into the overall trend than the current price itself.
The longer its length, the more data points that are included in the moving average calculation, which means the less any single price can affect the overall average.
If there are too many data points, price fluctuations may become “too smooth” that you won’t be able to detect any kind of trend!
Either situation can make it difficult to recognize if price direction may change in the near future.
For this reason, it’s important to select the length (or periods) that provides the level of price detail appropriate for your trading timeframe.
Now, you’re probably thinking, “C’mon, let’s get to the good stuff. How can I use this to trade?”
In this section, we first need to explain to you the two major types of moving averages:
We’ll also teach you how to calculate them and give the pros and cons of each. Just like in every other lesson in the BabyPips.com School of Pipsology, you need to know the basics first!
After you’ve got that on lockdown like Argentinian soccer player Lionel Messi’s ball-handling skills, we’ll teach you the different ways to use moving averages and how to incorporate them into your trading strategy.
By the end of this lesson, you’ll be just as smooth as Messi’s!
Are you ready?
If you are, give us a “Heck yeah!”
If not, go back and reread the intro.
Simple Moving Average (SMA) Explained
A simple moving average (SMA) is the simplest type of moving average in forex analysis.
Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X.
Don’t worry, we’ll make it crystal clear.
Calculating the Simple Moving Average (SMA)
If you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average!
You have the average closing price over the last five hours! String those average prices together and you get a moving average! If you were to plot a 5 period simple moving average on a 30-minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5 period simple moving average on the 4 hr. chart… Okay, okay, we know, we know. You get the picture!
Most charting packages will do all the calculations for you.
The reason we just bored you (yawn!) with a “how to” on calculating simple moving averages is because it’s important to understand so that you know how to edit and tweak the indicator.
Understanding how an indicator works means you can adjust and create different strategies as the market environment changes.
Now, as with almost any other forex indicator out there, moving averages operate with a delay.
Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of “future” short-term price action.
Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!
Here is an example of how moving averages smooth out the price action.
On the chart above, we’ve plotted three different SMAs on the 1-hour chart of USD/CHF. As you can see, the longer the SMA period is, the more it lags behind the price.
Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMAs.
This is because the 62 SMA adds up the closing prices of the last 62 periods and divides it by 62.
The longer period you use for the SMA, the slower it is to react to the price movement.
The SMAs in this chart show you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.
Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price.
With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average: they are susceptible to spikes.
When this happens, this can give us false signals. We might think that a new currency trend may be developing but in reality, nothing changed.
Exponential Moving Average (EMA) Explained
As we said in the previous lesson, simple moving averages can be distorted by spikes. We’ll start with an example.
Let’s say we plot a 5-period SMA on the daily chart of EUR/USD.
The closing prices for the last 5 days are as follows:
Day 1: 1.3172
Day 2: 1.3231
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
The simple moving average would be calculated as follows:
(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209
Simple enough, right? Well, what if there was a news report on Day 2 that causes the euro to drop across the board.
This causes EUR/USD to plunge and close at 1.3000. Let’s see what effect this would 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
The simple moving average would be calculated as follows:
(1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163
The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 was just a one-time event caused by the poor results of an economic report. The point we’re trying to make is that sometimes the simple moving average might be too simple.
If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmm… Wait a minute… Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods.
In our example above, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.
This would mean that the spike on Day 2 would be of lesser value and wouldn’t have as big an effect on the moving average as it would if we had calculated for a simple moving average.
If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders are doing recently.
Exponential Moving Average (EMA) vs. Simple Moving Average (SMA)
Let’s take a look at the 4-hour chart of USD/JPY to highlight how a simple moving average (SMA) and exponential moving average (EMA) would look side by side on a chart.
Notice how the red line (the 30 EMA) seems to be closer price than the blue line (the 30 SMA).
This means that it more accurately represents recent price action. You can probably guess why this happens.
It’s because the exponential moving average places more emphasis on what has been happening lately.
When trading, it is far more important to see what traders are doing NOW rather what they were doing last week or last month.
Simple vs. Exponential Moving Averages
By now, you’re probably asking yourself, which is better?
The simple or the exponential moving average?
First, let’s start with the exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go.
These can help you catch trends very early (more on this later), which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits (boo yeah!).
The downside to using the exponential moving average is that you might get faked out during consolidation periods (oh no!). Because the moving average responds so quickly to the price, you might think a trend is forming when it could just be a price spike. This would be a case of the indicator being too fast for your own good.
With a simple moving average, the opposite is true.
When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.
This would work well when looking at longer time frames, as it could give you an idea of the overall trend.
Although it is slow to respond to the price action, it could possibly save you from many fake outs.
The downside is that it might delay you too long, and you might miss out on a good entry price or the trade altogether.
An easy analogy to remember the difference between the two is to think of a hare and a tortoise.
The tortoise is slow, like the SMA, so you might miss out on getting in on the trend early.
However, it has a hard shell to protect itself, and similarly, using SMAs would help you avoid getting caught up in fakeouts.
On the other hand, the hare is quick, like the EMA. It helps you catch the beginning of the trend but you run the risk of getting sidetracked by fakeouts (or naps if you’re a sleepy trader).
So which one is better?
It’s really up to you to decide.
Many traders plot several different moving averages to give them both sides of the story.
They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.
There are a number of trading strategies that are built around the use of moving averages. In the following lessons, we will teach you:
- How to use moving averages to determine the trend
- How to incorporate the crossover of moving averages into your trading system
- How moving averages can be used as dynamic support and resistance
Time for recess! Go find a chart and start playing with some moving averages! Try out different types and try experimenting with different periods. In time, you will find out which moving averages work best for you.
How to Use Moving Averages to Find the Trend
One sweet way to use moving averages is to help you determine the trend.
The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it signals that price is in a general UPTREND.
If price action tends to stay below the moving average, then it indicates that it is in a DOWNTREND.
The problem with this is that it’s too simplistic.
Let’s say that USD/JPY has been in a downtrend, but a news report comes out causing it to surge higher.
You see that the price is now above the moving average. You think to yourself:
“Hmmm… It looks like this pair is about to shift direction. Time to buy this sucker!”
So you do just that. You buy a billion units cause you’re confident that USD/JPY is going to go up.
Bammm! You get faked out!
As it turns out, traders just reacted to the news but the trend continued and price kept heading lower!
What some traders do – and what we suggest you do as well – is that they plot a couple of moving averages on their charts instead of just one.
This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.
In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa. For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:
Above is a daily chart of USD/JPY. Throughout the uptrend, the 10 SMA is above the 20 SMA.
As you can see, you can use moving averages to help show whether a pair is trending up or down. Combining this with your knowledge on trend lines, this can help you decide whether to go long or short a currency.
You can also try putting more than two moving averages on your chart. Just as long as lines are in order (fastest to slowest in an uptrend, slowest to fastest in a downtrend), then you can tell whether the pair is in an uptrend or in a downtrend.
How to Use Moving Average Crossovers to Enter Trades
By now, you know how to determine the trend by plotting on some moving averages on your charts.
You should also know that moving averages can help you determine when a trend is about to end and reverse. All you have to do is plop on a couple of moving averages on your chart, and wait for a crossover.
If the moving averages cross over one another, it could signal that the trend is about to change soon, thereby giving you the chance to get a better entry. By having a better entry, you have the chance to bag mo’ pips!
If Allen Iverson made a living by having a killer crossover move, why can’t you?
Let’s take another look at that daily chart of USD/JPY to help explain moving average crossover trading.
From around April to July, the pair was in a nice uptrend. It topped out at around 124.00, before slowly heading down. In the middle of July, we see that the 10 SMA crossed below the 20 SMA.
And what happened next?
A nice downtrend! If you had shorted at the crossover of the moving averages you would have made yourself almost a thousand pips!
Of course, not every trade will be a thousand-pip winner, a hundred-pip winner, or even a 10-pip winner.
It could be a loser, which means you have to consider things like where to place your stop loss or when to take profits. You just can’t jump in without a plan!
What some traders do is that they close out their position once a new crossover has been made or once price has moved against the position a predetermined amount of pips.
This is what Huck does in her HLHB system. She either exits when a new crossover has been made, but also has a 150-pip stop loss just in case.
The reason for this is you just don’t know when the next crossover will be. You may end up hurting yourself if you wait too long!
One thing to take note of with a crossover system is that while they work beautifully in a volatile and/or trending environment, they don’t work so well when price is ranging.
You will get hit with tons of crossover signals and you could find yourself getting stopped out multiple times before you catch a trend again.
How to Use Moving Averages as Dynamic Support and Resistance Levels
Another way to use moving averages is to use them as dynamic support and resistance levels.
We like to call it dynamic because it’s not like your traditional horizontal support and resistance lines. They are constantly changing depending on recent price action. There are many forex traders out there who look at these moving averages as key support or resistance. These traders will buy when price dips and tests the moving average or sell if price rises and touches the moving average.
Here’s a look at the 15-minute chart of GBP/USD and pop on the 50 EMA. Let’s see if it serves as dynamic support or resistance.
It looks like it held really well! Every time price approached 50 EMA and tested it, it acted as resistance and price bounced back down. Amazing, huh? One thing you should keep in mind is that these are just like your normal support and resistance lines.
This means that price won’t always bounce perfectly from the moving average. Sometimes it will go past it a little bit before heading back in the direction of the trend.
There are also times when price will blast past it altogether. What some forex traders do is that they pop on two moving averages, and only buy or sell once price is in the middle of the space between the two moving averages.
You could call this area “the zone.”
Let’s take another look at that 15-minute chart of GBP/USD, but this time let’s use the 10 and 20 EMAs.
From the chart above, you see that price went slightly past the 10 EMA a few pips, but proceeded to drop afterwards.
There are some traders who use intraday strategies just like this.
The idea is that just like your horizontal support and resistance areas, these moving averages should be treated like zones or areas of interest.
The area between moving averages could considered as a zone of support or resistance.
Breaking through Dynamic Support and Resistance
Now you know that moving averages can potentially act as support and resistance. Combining a couple of them, you can have yourself a nice little zone.
But you should also know that they can break, just like any support and resistance level!
Let’s take another look at the 50 EMA on GBP/USD’s 15-min chart.
In the chart above, we see that the 50 EMA held as a strong resistance level for a while as GBP/USD repeatedly bounced off it.
However, as we’ve highlighted with the red box, price finally broke through and shot up.
Price then retraced and tested the 50 EMA again, which proved to be a strong support level.
So there you have it folks!
Moving averages can also act as dynamic support and resistance levels.
One nice thing about using moving averages is that they’re always changing, which means that you can just leave it on your chart and don’t have to keep looking back in time to spot potential support and resistance levels.
You know that the line most likely represent a moving area of interest. The only problem of course is figuring out which moving average to use!
Summary: Using Moving Averages
There are many types of moving averages. The two most common types are a simple moving average and an exponential moving average.
Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
Exponential moving averages put more weight to recent price, which means they place more emphasis on what traders are doing now. It is much more important to know what traders are doing now than to see what they did last week or last month.
Simple moving averages are smoother than exponential moving averages.
Longer period moving averages are smoother than shorter period moving averages. Using the exponential moving average can help you spot a trend faster, but is prone to many fake outs.
Simple moving averages are slower to respond to price action, but will save you from spikes and fake outs.
However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
You can use moving averages to help you define the trend, when to enter, and when the trend is coming to an end.
Moving averages can be used as dynamic support and resistance levels.
One of the best ways to use moving averages is to plot different types so that you can see both long-term movement and short term movement.
You got all of that? Why don’t you open up your charting software and try popping up some moving averages?
Remember, using moving averages is simple. The hard part is determining which one to use!
That’s why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want to use them as dynamic support and resistance.
Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.