Financial markets are often driven by trends - whether upward or downward – which can be identified through trend patterns and technical indicators. Such technical indicators are usually back-tested and tested live in all pairs to provide consistency to the analysis they are based on. A lot of experienced traders and other market participants analyze financial markets using Technical Indicators. Technical Analysis

helps to keep the price action on track. In other words, it provides indications such as: at what price to buy or sell ; if a currency pair will continue its trend; if it will start a tend reversal, etc.

WHAT IS A MOVING AVERAGE?

Moving Average (MA) is one of the most common, useful and efficient tools used in technical analysis, which helps to understand the price action by

knowing the price direction or trend, and take decisions based on such indication. It helps to understand the particular trend of a currency pair at a given period of time.

Moving averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth

Basic application of Moving averagesas a part of a forex trading strategy

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price action and filter out the noise.

By definition it is the average price of a currency pair - or any other asset - over a specified period of time. In simple terms, the moving average is calculated by adding prices (generally closing prices but not necessarily) over “n” recent time periods and then dividing the result by the number of time periods.

Moving Average (n) = Price (1) + Price (2) + Price (3) +…+ Price (n) / n*

A simple moving average is formed by computing the average price of a security over a specific number of periods. Most moving averages are based on closing prices. A 5-day simple moving average is the five day sum of closing prices divided by five. As its name implies, a moving average is an average that moves. Old data is dropped as new data comes available. This causes the average to move along the time scale. Below is an example of a 5-day moving average evolving over three days.

Daily Closing Prices: 11,12,13,14,15,16,17

First day of 5-day SMA: (11 + 12 + 13 + 14 + 15) / 5 = 13

Second day of 5-day SMA: (12 + 13 + 14 + 15 + 16) / 5 = 14

Third day of 5-day SMA: (13 + 14 + 15 + 16 + 17) / 5 = 15

There are 2 types of MAs commonly used by market players, which are Simple Moving Average (SMA) and Exponential Moving Average (EMA).

A SMA is simple to understand as it regularly calculates the average price of any currency pair by using a certain time period. For instance, if the time period of a MA is 10, that means it will calculate the average price of the previous 10 candlesticks (which can be based on minutes, hours, days, weeks, months or years). If the SMA is called “a 10 Day MA” that means it calculates the average price of the last 10 trading days on a continuous basis.

The EMA puts more weight towards recent data and less weight towards past data and, as a result, is an indicator that is often used. The EMA is calculated by applying a percentage of today’s closing price to yesterday’s MA value. When using this indicator it is important to keep in mind that it is more responsive to new information and it is for this reason that many investors choose to use this average among all the other different types of moving averages.

Exponential moving averages reduce the lag by applying more weight to recent prices. The weighting applied to the most

recent price depends on the number of periods in the moving average. There are three steps to calculating an Exponential Moving Average. First, calculate the Simple Moving Average. An Exponential Moving Average has to start somewhere so a simple moving average is used as the previous period’s EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the Exponential Moving Average. The formula below is for a 10-day EMA.

SMA: 10 period sum / 10

Multiplier: (2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)

EMA: {Close - EMA(previous day)} x multiplier + EMA(previous day).

We won’t go into details to explain the EMA, as our purpose here is to show how to use such kind of Moving Averages in currency trading.

USING MA’S FOR TRADING

MA is one of the simplest indicators, however there are various kinds of parameters, which can be used to make it more extensive and thorough.

It is a trend following indicator, which is used to detect the start of the trend, to follow its progress

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and to predict with a certain degree of confidence when any reversal can occur. There are many ways to use a MA to analyze charts.

The length of the moving average depends on the analytical objectives. Short moving averages (5-20 periods) are best suited for short-term trends and trading. Chartists interested in medium-term trends would opt for longer moving averages that might extend 20-60 periods. Long-term investors will prefer moving averages with 100 or more periods.Some moving average lengths are more popular than others. The 200-day moving average is perhaps the most popular. Because of its length, this is clearly a long-term moving average. Next, the 50-day moving average is quite popular for the medium-term trend. Many chartists use the 50-day and 200-day moving averages together. Short-term, a 10-day moving average was quite popular in the past because it was easy to calculate. One simply added the numbers and moved the decimal point.

SIMPLE APPLICATION OF MOVING AVERAGE

• Identifying the trend using a single Moving Average

We can recognize the general trend of the market by comparing

the current price of any currency pair to its Moving Average, as shown on the chart (see Figure 1). When the price of a currency pair is currently trading above the MA then the trend is said to be upwards (bullish) and if the currency pair is trading below the MA then the trend is downwards (bearish). Whenever the price of a

currency pair crosses the MA the trend of the currency pair changes from up to down and vice versa. At this crossing level you could enter the market to make a profit by betting on the trend. When the candlesticks have crossed the MA from lower to above then it gives an indication that the market trend has changed to upwards and

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Figure 1

Figure 2

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the price of the currency pair will go further up.

For instance the chart on Figure 2 shows that on 28th August, the MA crossed the price trend and if you had taken a buy position when the candlesticks were above the MA line at around 1.2510 and sold at the crossover at 1.2550 then you would have made 40 pips profit. If you had taken a buying position at this first price with 1 standard lot then you could have incurred a profit of 400$ on EURUSD in a couple of hours.

• Using the Moving Average to find support or resistance levels

The MA can also act as a ‘support’ or ‘resistance’, especially with longer time periods.

Support is a price level below the current price at which demand is thought to be strong enough to prevent the price from falling further. Resistance levels are the opposite of the support level, where the price level is above the current price at which supply is sought to be strong enough to prevent the price from rising further. Both support and resistance levels are developed when a particular currency price is repeated at a particular price level.

Once we have understood the market trend using the MA as explained above, the next step is to understand what time period should be used. The answer is simple as there is no fixed rule, and choosing a particular period is based on personal judgment.

Any MA should be back tested

and watched carefully to see if it is helping to know the trend.

The slope of the MA depends on whether a shorter or longer period is applied. The shorter the time period, the ‘steeper’ the slope –similar to the shape of the ‘wave’- and the longer the time period the “flatter” the slope.

Figure 3

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With a shorter time period you can use the MA to :

a) identif y the market trend, whether upwards or downwards

b) determine whether the trend is going to continue or reverse by using support or resistance

levels.

But with a longer MA period, a different approach is used to predict the prices :

a) When the slope is flat, it can be more effective to use the MA line as Support or Resistance levels.

b) The same principle can be applied to understand the trend or direction, but the trading activity may be l imited with lack of opportunities for entr y points .

If a key MA level is tested, the price may ver y well bounce off this level or completely breach it . Knowing that price wil l help react and place orders according ly.

• Using MA as an indicator of general trend based on the 2 different moving averages:

We have g one throug h the use of a sing le moving averag e - using a short term or long term trend. Let’s now g o throug h the use of 2 MA’s at the same time.

Identif ying a trend is important but relying on a sing le MA Indicator mig ht not a lways be enoug h, therefore it is sometimes better to use more than one MA at the same time to g et further confirmation of the direction of the market. When we use two MAs with different time periods we often g et a strong er indication of the trend in the market than relying on a sing le MA .

Place any 2 MA’s on the chart ;

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Figure 4

Figure 5

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one would be a shorter MA and the other would be a long er MA . When the shorter MA crosses the long er MA from below, then it provides an strong er indication to buy, as the trend is confirmed bull ish from both the MA’s. When the Shorter MA crosses the Long er MA from above then it would g ive an indication to sel l , as the trend is assumed as bearish. For instance, the two MA’s used in Fig ure 6 are a 14-hour MA and 21-hour MA making a crossover, which provides an indication for a chang e of trend.

Both the MA’s used on that chart have relatively short time periods, but a larg er time period can a lso be used in the same way (Ex . a 100 Hour MA , or a 200 Hour MA).

- When using a shorter time period you g et an early indication of the trend but the accurac y of the trend is lower.

- When using a long er time period MA you g et a later indication of the trend but the trend is much more precise.

You can use more than 2 MA’s at the same time for deeper analysis of a currenc y pair but you should be careful because using too many MA’s can become confusing . Using between two to four MA’s at the same time is appropriate for having an effective trading system.

The importance of t ime frames when using MA’s

Traders use different time

frames (short, medium or long -term) depending on their trading style. Different time frames and different pairs wil l have different MA’s.

Throw a few MA’s on a chart and see if you can spot any pattern. If you see a MA where price is constantly bouncing off, you mig ht have found a key MA that could be a part of a profitable trading system.

CONCLUSION

MA’s are trend fol lowing , or lag g ing , indicators that wil l a lways be lag g ing . This is not necessarily a bad thing thoug h. After a l l , the trend is your friend and, in that sense, it is better to trade in the direction of the market. MA’s insure that a trader is in l ine with the current trend. Note that, during trading rang es, moving averag es are ineffective. Once in a trend, moving averag es wil l keep you in, but they wil l a lso g ive you late signals . Don’t expect to sel l at the top and buy at the bottom using MA’s. As with most technical analysis tools, MA’s can be used in conjunction with other technical anlaysis tools, for more accurate strateg ies and trading signals .

Avinash Bhojwani

Figure 6

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