Moving Averages in Forex

Good time of the day. Today’s lesson is classified as “Forex for Beginners” and professional traders will hardly hear anything new here. I was several times asked in the comments about the seemingly banal indicator Moving Average. Many beginners do not understand: what kind of moving averages and with what period to use. In this tutorial, I have tried to explain in the clearest form principles of working with moving averages while trading on Forex.

Moving Average - is one of the oldest technical indicators and, perhaps the most popular and most commonly used, as on its base huge variety of other indicators are build.

The moving average is nothing else than the average price of a currency pair, in a case with Forex - over a period of time expressed as a number of candles, bars. For example, let’s put red color moving average with period 8 on a chart.

It shows the average price for the last 8 candles. Naturally, after 8 candles pass, it takes away the first candle from its calculations and starts computation from the second to ninth. If we set period 21 instead of 8, the average price of a currency pair over the last 21 candles will be calculated.

Thus, we can see the general trend, which is a bit smoother, more pronounced than the usual chart. In general, it is assumed that if the price is above the moving average then there is an uptrend, if below the moving average then downtrend. Herein, the higher the period of moving average is, the more long term is the trend. For example, with the period of the moving average 21, we can say that if the price is above it, it’s quite a short-term uptrend.

If the moving average period is much bigger, let’s say 200, and the price is above the moving average with a period of 200, we can say that there is a significant upward trend. If the price is below the moving average with a long period (eg, 200), we understand that there is quite a serious downward trend.

In other words, the longer the period of moving average, the more clumsy it is since it has to calculate the average value for the last candles (in this case 200). That’s a lot. And, accordingly, the greater the period of moving average, the more important it is in the long term.

How to put the moving average on the chart?

It’s easy. In Metatrader 4 terminal, press Insert > Indicators > Trend > Moving Average

When you apply the indicator to the chart, you are offered to choose a Period: the most popular periods are: 5, 8, 21, 50, 100, 200, 265. Of course, You can try any other period You want. Shift: if, for example, you need to move the moving average just a bit higher or lower, create two moving averages, and thus build a canal. But the shift is rarely used.

Apply to: After that we can choose to which side of a candle moving average to use, that is the average of what will be calculated. By default, an average closing price is calculated. You can make that calculated is an average value of the opening, the middle point, the highest point of the candle – High, the lowest point - Low, also you can calculate the average of the mid-point of the candle, and so on.

In Style, we can choose the color, line thickness and what it will be - dotted or dashed-dot.

MA method: there are several types of moving averages. First - simple, exponential, smoothed and linear weighted.

For example, let’s put on the chart an exponential moving average with a period 21 red color. For comparison let’s draw a simple moving average of the same period, but blue. So, we have a simple blue, with a period of 21, and exponential red with a period of 21. What is the difference?

Exponential moving average attaches greater importance to the latest data. In our case, it assigns value in descending order beginning from the last bar.

The last bar receives the greatest importance. Further importance reduces, down to 1 out of 21 bars, and exponential moving average becomes less sensitive. It is the most sensitive at the last bar and less sensitive at the last by one and so on, down to the first bar (depending on what timeframe you have set).

Simple Moving Average assigns equal importance to the last and the first bar. Therefore, the exponential moving average is slightly more sensible to changes that occur on the last bar of this chart. And for this reason, it is used more often than the Simple moving average. For short timeframes, an exponential moving average is often used.

But for longer periods - 200, 265 - it is possible to use a simple moving average because the difference between it and exponential is negligible. Let’s add another moving average, this time weighted with the same period, 21, and make it dark green. This weighted moving average of the same period, 21 as our previous line. It is linear-weighted.

What’s the difference between linear weighted moving average and the exponential? If I may say so, it is a different version of exponential moving average. It distributes the bars importance somewhat differently, but also attaches special importance to the last bar and assigns them different weights. While the value of the bars in exponential moving average decreases more smoothly, bars weight decreases in linear weighted moving average faster.

If, say, we have the last bar - 4n, last by one - 2n, the one before n, then n/2. It means that it is more dependent on price fluctuations. For this reason, it is not very popular, and a linear weighted moving average is rarely used.

And the last but not the least calculations type that we didn’t mention is a Smoothed moving average. Let’s put it on our chart in golden color.

Although, as we see, golden smoothed moving average has the same period as the previous ones - simple, exponential and weighted moving averages, but golden smoothed moving average looks like it has a longer period, although periods in all our calculations are the same - 21.

Why does it happen? Smoothed moving average is between simple and exponential moving average. But at the same time, simple moving average takes into account each time only a certain period of time that we’ve set (in our case it is 21), smoothed moving average accounts for the time period that we’ve set, but also it takes into account the previous bars, which are outside the period, which we’ve set - in this case 21. This moving average checks previous bars, takes them into account, but gives them each time less and less value as that they move back from the present moment. Thus, we get a smoothed version, which is suitable to identify any long-term trends. Accordingly, it is desirable to set a longer period.

Therefore, smoothed moving average automatically increases the period that we put in the settings, and thus is more fixed than other types of moving averages. It is used very rarely. In my practice, I hardly remember any situation, when it was used. However, this information may be helpful.

What kind of moving average to use?

Most often, traders prefer to deal with the Exponential moving average, and for longer periods - to use a Simple moving average. You can forget about the other types.

You should understand that the longer the period, the more stable moving average is and the bigger value it has when the price has reached and crossed it or, for example, was below, and became above.

What period should be used in trading? More often - short-medium that traders use. They are 8 and 21. Long moving averages are 50, 100, 150, 200, 365. You should remember that the greater the period of moving average, the less agile it is, the more significant price movement you need to change its direction, reverse.

How can we use moving averages to trade?

Classic books on trading often considered the notion of “crossing” - when the fast moving average, for example, red line 8EMA crosses upwards the blue line - 21EMA, it means you should buy.

Or vice versa, fast moving average (8 EMA) crosses downwards the slow one (21EMA) It is a signal to sell.

The most common use of the moving average is considered as their intersection. In general, it is believed that such an approach is obsolete. As the market has become less trendy, there is a lot of “market noise”, up and down movements.

Because when the lines cross, it is often too late to buy or sell, as they follow the price and are late, that is, give a signal when the trend has lost its original strength. And when you buy, the price can move quite a bit, and then comes a reversal. Thus, you shouldn’t use moving average cross as a signal to open a position.

More logical, we can consider it as a kind of confirmation of our logic of looking for a trend. Suppose, we look at the D1 chart and think that now we are with the trend.

Fast moving average (Red line 8EMA) crosses upwards the blue line - 21EMA - and we can say in general that there is an upward trend. Later, 8 EMA crosses downwards the slow one 21EMA - it means, that general trend is downward.

That is, the moving average can be used by us as a kind of additional filter for making a decision about the current trend, which is present on the market and, consequently, to open additional positions on our other signals. We can also use the angle of inclination of our lines. The steeper it is, the stronger the trend. Accordingly, this moving average is used for a long period, 20 and higher. The higher it is, the steeper the angle of the moving average, the stronger the trend.

Let’s open GBP/USD chart, D1 timeframe and put 4 simple moving averages: 100, 150, 200 and 365.

As you can see from the chart, the price of some moving averages goes back, tests them and pushes them off and continues the old trend. Thus, we can consider moving averages as a certain dynamic level of resistance/support, dynamic trend lines that constantly follow the price.

If there is no resonance level nearby, but there is a moving average with a period of more than 20, we may fully use it as a certain level, and if there is an additional signal to assume that the price has pushed off him, and rely on the trend continuation that has taken place previously.

Also, you can put stop-loss outside of the moving average and move it as the price goes closer to it. You can use moving averages as a kind of signal to exit or close a position. The crossing of moving averages should not be used to enter a position, but to exit it - yes. If you have a long-term trades, as soon as moving averages with small periods cross, close the trades and thus find the end point of current trend.

 

Conclusion

In this lesson, I didn’t mention about the formulas used to calculate different types (methods) of moving averages. Why? I believe that such formulas are not so interesting for ordinary traders like you and me, more important is their purpose and ways to use them in trading. After all, not everyone knows how TV or microwave oven work, and it does not prevent us from using these devices. If you still need the formulas of moving averages of all types, which are presented in Metatrader 4, you can find them in the help about the program by pressing F1 inside the terminal.

Take care, Michael

ForexTraderPortal.com