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The Basics of Moving Averages

The Basics of Moving Averages

Moving averages are among the most commonly used indicators used by traders in forex. They are a method of streamlining price trends by eliminating market noises. Many of the technical trend-following systems today are based on the moving averages system.

What Are Moving Averages?

Moving averages are indicators that show the mean closing price of a market over specified durations of time. You could use this method to determine the most opportune moment to join or exit a market because they are good indicators of a market’s momentum.

The most popular types of moving averages are simple moving average (SMA) and exponential moving average (EMA). The primary difference between the EMA and SMA is the sensitivity that each shows to changes in the price values used in their calculations. While the SMA gives you the average price data, the EMA gives more weight to the current data.

Nearly all charting packages use moving averages, especially the SMA and EMA, as technical indicators. The SMA is obtained from the division of the number of points by the average data points in the series.

The most significant limitation of the SMA is that all data points could have equal weighting, which at times fails to give you the true reflection of the most current market trends.

The EMA rectifies this limitation by disregarding the last market value and giving more weight to the most recent market prices. The EMA is, therefore, more sensitive to current market price trends compared to the SMA. It is an excellent indicator of trend direction.

How to Calculate Moving Averages

The SMA is calculated using the following formulae:

A represents each data point while N is the number of points.

The EMA is calculated using the following formulae:

EMAt represents the value of EMA today

Vt is the value today

S represents smoothing while d denotes the number of days

To find EMA, select a particular period, then use the formula above to determine the multiplier for weighting the EMA. Once you get the answer, use the smoothing and previous EMA to get the current value.

How Are Moving Averages Interpreted?

Before you interpret moving averages, it is essential to understand why moving averages are used. There are three ways that you could use a moving average:

You could use a moving average to:

  1. Determine the direction of the market trend
  2. Figure out the support and resistance levels
  3. And to monitor long-term and short-term market trends using multiple moving averages.

Using Moving Averages to Determine the Direction of the Market Trend

Moving averages always take an upward direction when the prices in the marketing are trending higher to indicate the increasing price values. This would be a good indicator for entering the market by buying opportunities while the prices are booming.

When the prices are below the moving average indicators, the prices in the market are low. This downward trend would be a strong indicator of an opportunity for you to sell.

Figuring Out the Support and Resistance Level 

Once you place a trade, you could use the moving average to determine the resistance and support levels. If the moving average is trending high, it could be an excellent opportunity to enter the market on a retest of the moving average.

However, if you are in an uptrend market, you could use the moving average to prevent incurring losses using it as a stop loss level.

Using Multiple Moving Averages to monitor long-term and short-term market trends.

You could use multiple moving average indicators on a single chart to simultaneously assess the long-term and short-term trends in the market. Using multiple moving average indicators to accurately interpret the prices as they cross over and below the plotted levels as strengths or weaknesses for particular currency pair.

The use of multiple moving averages is very similar to the MACD oscillator and is a valuable tool for determining the trends in the market price. When using this tool, be observant to see when the lines cross. When a bullish line is formed, the phenomenon is known as ‘The Golden Cross,’ and when the lines form a bearish pattern, the phenomenon is called ‘The Death Cross”.

The Golden cross occurs when the short-term moving average of a specified period crosses above the long-term moving average, for instance, 50day moving average crossing over a 200-day moving average. The Death Cross, on the other hand, represents a cross between a short-term moving average over.

If you are trading in the long term, you should consider the Death cross as a time to close the trade. But if you are dealing in the short-term, consider the golden cross as a sign for closing out the trade.

Moving Averages are good indicators to use for eliminating fluctuations that make your trading decision-making turbulent. These indicators allow you to identify all trends in the market simply and straightforwardly.