What are Moving Averages?
Moving averages are one most commonly used technical indicators. A moving average is simply a way to smooth out price fluctuations to help you distinguish between typical market “noise” and the actual trend direction. By “moving average”, we mean that you are taking the average closing price of a currency pair for the last ‘X’ number of periods. Like every technical indicator, a moving average (MA) indicator is used to help us forecast future prices. By not just looking at the price to see what’s happening? The reason for using a moving average instead of just looking at the price is due to the fact in the real world, aside from Santa Clause not being real…..trends do not move in straight lines. Price zigs and zags so a moving average helps smooth out the random price movements and help you “see” the underlying trend.
A simple moving average (SMA) is the simplest type of moving average. Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X. You plotted a 5-period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average! If you were to plot a 5-period simple moving average on a 30-minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5. With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging. There is one problem with the simple moving average: they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new currency trend may be developing but in reality, nothing changed.
Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods.
In our example above, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5. This would mean that the spike on Day 2 would be of lesser value and wouldn’t have as big an effect on the moving average as it would if we had calculated for a simple moving average.
If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders have been doing recently.