The moving average is one of the most popular indicator used by technicians.
We have 3 different types of moving average: the simple moving average (SMA), the weighted moving average (WMA) and the exponential moving average (EMA).
The simple moving average is just the average of all the prices selected.
For example, let’s say that we want to calculate the last 5 closing prices for EUR/USD. The first candle closes at 1.15, the second closes at 1.17, the third at 1.1550, the fourth at 1.16 and the fifth at 1.1650.
So we need to do:
The general formula is:
Where n is the number of candles that we decide to analyse.
So what if you want to analyse last 5 candles? This simply means that n = 5 and you need to add all the prices, starting from the first one, where K = 1, till K = 5, that is last candle’s price. Once you add all the prices, you divide by 5, because n = 5.
Don’t worry this doesn’t mean that you have to get a degree in mathematics to use the moving average. I have introduced the formula just to let you understand better what I’m going to explain later on.
Anyway why do we call this indicator moving average and not just average?
This is because every time that a new candle is formed, this replaces the oldest candle that was included in the calculation of the average.
Let’s take back the previous example:
(1.15 + 1.17 + 1.1550 + 1.16 + 1.1650) / 5 = 1.16
These 5 prices refer to the closing prices of the last 5 candles. When a new candle is formed on the market, the moving average will automatically replace the oldest price with the new one. So the moving average will not include 1.15 anymore in its calculation, but will have the new price.
Let’s say that the new price is 1.18. The new moving average level then will be:
(1.17 + 1.1550 + 1.16 + 1.1650 + 1.18) / 5 = 1.1660
So the average is “moving” up (1.16 –> 1.1660) after the formation of the last candle, that’s the reason of the name moving average and not just average.
For the SMA, every price contributes in the same way. So each price contributes 1/5 to the total moving average that we have calculated. This means that if we choose a small number of candles to calculate the SMA, the indicator will be very sensitive to every recent price action. This is good from one side, because you can have a better understanding of recent price movements, but from another side, it is very easy to get caught in anomalous price movements that will give you false signals.
To try to avoid false signals, you can try with a longer term simple moving average, that has a smoothing effect, but it will be less responsive to recent prices. So you need to try to balance the advantages and disadvantages of having a short term and long term moving average.
If you want to choose a long term moving average but you are afraid that you are not giving much importance to recent candles, you can have a look at the weighted moving average. This kind of average assigns different weights to each price and the most recent prices are weighted more heavily than older prices. You can also choose how to weight the data, but I’m not going into it.
Last type of moving average is the exponential moving average that can be considered a special type of WMA. The EMA assigns progressively smaller weights to each of the past prices. Each weight is exponentially smaller than the previous weight, that’s the reason of the name exponential moving average. This is probably the most used one by Forex traders.
In practical terms?
- Which one should I use?
- How many candles do we include in the calculation?
- How to use it?
The type of moving average that you are going to use is a very personal choice.
As I suggest in my course about candlestick patterns and price action, if you use candlestick patterns to analyze the price, they already focus on last candle formations on the market, so there’s no need to use an indicator that puts more emphasis on recent price action. In that case, using the SMA would make more sense.
These small details separate a profitable trader from all the others. There’s no point to use the 200 EMA only because you have heard that top traders use that one. You need to fully understand what you use and what you do.
The number of candles is another personal choice. I would recommend not to go under 5 candles and not to go over 200 candles. I personally like a period of 24 candles. I consider 24 a magic number in Forex trading. It fits almost all the time frames.
If you use a 15 minute time frame, 24 candlesticks will give you information about last 6 hours; if you use the hourly chart, you monitor what happened during the last 24 hours. If you use a 4-hour chart, you have 96 hours, that is exactly 4 days. So I love the number 24 in Forex trading because it seems to fit perfectly every time frame.
If I also want to have a long term moving average, I choose 120 as a period.
Now let’s face the most important question: how to use the moving average?
There are hundreds of techniques that involve this indicator. If you search for them on google, you will find a lot them, but I can’t guarantee that they will be effective. I will show you here the most important techniques to try to understand better the market.
- Comparing the price with the moving average. This is very simple, if the price is over the MA, we can assert that the market is in an uptrend. If the price is below the MA, we will say that the market is in a downtrend. This is obviously very general, because it doesn’t include 2 necessary factors like the time frame and the period of the moving average. It wouldn’t make sense to say that the market is in an uptrend if we are studying the moving average on a 5 minutes chart, with a period of 5 candles. More about the time frames here: What Is The Best Time Frame To Trade On Forex?If you want to use this technique, my suggestion is to use a time frame of 1 hour or higher, and a period of 24 candles or higher.
- Using the moving average as support and resistance levels. Well, this doesn’t need further explanation, I think it’s quite self-explanatory. In addition, in the previous chart there are 2 good points that could be used as support, can you see them? 😉
- Last trading strategy I want to show you is called the crossover and it needs 2 moving averages. One will be a short period moving average and the other will be a long period one. When the short term MA crosses above the long term MA, we have a bullish signal; when the short term MA crosses below the long term MA, we have a bearish signal. Why does this make sense? Because we have said that a moving average that includes a smaller number of candles is more sensitive to recent price action, so when the short term moving average crosses the long term moving average, it is showing that recently the price is deviating from long term action, so it can initiate a new trend or simply a retracement from the main trend.
In the course about price action, I also have an important lecture showing how to use the moving average with the candlesticks to analyze the market and open your positions.
It took me a long time to summarize all the researches, all the trades, all the material, all the books I have read, all the courses I have attended. For this reason the price for the course is $199. It is for intermediate and expert traders and I consider it a MUST for all the traders that are still struggling to understand the dynamics of the market.
But, as you know, I often publish insane discounts in the educational page to celebrate milestones with my students.
Maybe I will give a coupon with a 95% discount if I reach 10 comments for this post 🙂