What is a moving average?
Moving averages simply measure the average price or exchange rate of a currency pair over a specific 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 is complex, but fortunately for trackers, 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.
10, 20, 50 and 200-Day SMAs on non-Daily Charts
Also note that as you change your time frame in the chart (say, changing a daily chart into an hourly), the moving average will need to change too. If you want a 10-day moving average line on an hourly chart, you would need a 240-hour SMA (that is 10-day times 24 hours).
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 EMA. Hitting the 20 day EMA, 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 EMA crossed below the 200 day EMA), this may be seen as an indication that the pair will move in the direction of the shorter MA (so, in the aforementioned example, it would move down). Accordingly, should the short EMA crosses back above the longer EMA (i.e. the 20 day EMA crossed above the 200 day EMA), this may be viewed as a possible change in the trend (so, in the aforementioned example, it would move up). Historically, moving average crossovers tend to ‘lag’ the current market action. The reason being is that the moving averages give us an ‘average’ price over a given period of time. Therefore the moving averages tend to reflect the market’s action, only after at least some time has past. As the short moving average crosses over and above the longer moving average, this can be interpreted as a change in trend to the upside. The opposite also holds true, as the short moving average crosses down and below the long moving average, a new downtrend may emerge in the near future. Moving average crossovers tend to generate more reliable results in a trending market that tends to accomplish either new highs or new lows. In a range bound market environment, the moving averages may cross one another many times, and may tend to give us false trading signals. It is important for this reason, that we first identify the market as either trending or range bound.
The top chart below show an example of how moving averages, when confirmed by price action, can signal trading opportunities.
In second chart we see moving averages applied to the AUD/NZD currency pair (although examples for this are easily found with all pairs). Notice the Three Outside Up pattern that penetrates the 20-moving average (Black Line) at the same time the 50-Day SMA (Yellow) crosses over the 200-Day SMA(Green). This reversal pattern, and the fact that price bounces off of the 200 moving average, shows that the downside momentum is lost, and signals that a rally may follow.