Using Moving Averages

What is a moving average?

Moving averages simply measure the average price or exchange rate of a currency pair over a specified time frame. For example, if we take the closing prices of the last 10 days, add them together and divide the result by 10, we have created a 10-day simple moving average (SMA).

There are also exponential moving averages (EMAs). They work the same as a simple moving average, except they place greater weight on the more recent closing prices. The mathematics of an exponential moving average are complex, but fortunately most charting packages calculate them automatically and instantaneously.

Parameters. The most commonly used time frames for moving averages are 10, 20, 50, and 200 periods on a daily chart. As always, the longer the time frame, the more reliable the study. However shorter term moving averages will react more quickly to the market's movements and will provide earlier trading signals.

How to Use Moving Averages in Trading

• Enter when a strong trend pulls back to a moving average line
• Enter on a moving average crossover.

Gauge overall trend. Moving averages display a smoothed out line of the overall trend. The longer the term of the moving average, the smoother the line will be. In order to gauge the strength of a trend in a market, plot the 10, 20, 50 and 200 day SMA’s. In an uptrend, the shorter term averages should be above the longer term ones, and the current price should be above the 10 day SMA. A trader’s bias in this case should be to the upside, looking for opportunities to buy when the price moves lower rather than taking a short position.

Confirmation of price action. As always, traders should look at candlestick patterns and other indicators to see what is really going on in the market at the time. The chart above points out the Bullish Engulfing pattern that occurs just as the pair bounces off the 20 day SMA. Hitting the 20 day SMA, in conjunction with the candlestick pattern, suggests a bullish trend. Traders should enter once the Bullish Engulfing candle is cleared.

Crossovers. When a shorter moving average crosses a longer one (i.e. if the 20 day SMA crossed below the 200 day SMA), that is viewed by many as an indication that the pair will move in the direction of the shorter MA (so, in the aforementioned example, it would move down). Historically, moving average crossovers have not been accurate trade indicators, but they do offer insight into the market’s psychology. Accordingly, should the pair move in the opposite direction of the shorter SMA and thus cross it, this should be viewed as an opportunity to enter a position.