The moving average (MA) is one of the most basic and frequently used technical analysis tools. Moving Averages are used by traders to find trends, verify new trends and spot trends about to change direction.
There are three types of MA’s: Simple, Weighted and Exponential.
In a simple MA each data point in the specified period is given equal weight. The user needs to define whether the high, low or close is used, these data points are then added together and averaged. As each data point is included in the equation a line is formed and the oldest data point in the sample is dropped.
A weighted MA gives more emphasis to the latest data. Each data point is multiplied by a weighting factor which will move every day. These figures are then added and divided by the total of the weighting factors. This provides smoothing to a curve of prices while being more responsive to the latest price movements.
An exponential MA is another method of giving more emphasis to the latest data. A percentage of the current price is multiplied by the preceding period’s average price.
Fortunately, nearly all charting packages do all the calculations for you.
Traders look to find the optimum MA for a particular currency pair. This process involves testing the different types and varying the time periods used to find a fit for the price data.
Many traders use more than one different MA on each price chart. For example a trader could use a 5 period, 13 period and 60 period on the same price chart. The trader will observe how they can be used collectively to provide confirmation for a trade.
Larger MA’s (eg. the 60 period) can help the trader to find the long term trend, but lag behind the price and are slow to react to a changing trend. Smaller MA’s (eg. the 5 period) can help to spot short term trends and reversals, they follow the price trend pretty closely but provide less of a smoothing look than a longer period.
Traders often look for an average that has been a line of support or resistance historically. This line is then used to enter stops, profit targets and observe trend reversal opportunities. Many traders also wait for the lines to cross over to verify a trade opportunity.
Like any other technical indicator, this indicator works with a delay. The line is just a forecast of what could occur in the future, not a guarantee of what will occur.
There are other more complex moving averages you could come across.
– Double Exponential (DEMA)
– Triple Exponential (TEMA)
– Least Squares
– Time Series
– Zero Lag Exponential
The best way to learn how these different MA’s react to price data is to open up a Forex (or stock) trading demo account and test them out on a chart.
Source by Jon Provencher