Price
Smoothing
A moving average is
simply a way to smooth out price action over time. By “moving average”,
we mean that you are
taking the average closing price of a currency for the last ‘X’ number of
periods.
Like every indicator, a
moving average indicator is used to help us forecast future prices. By
looking at the slope
of the moving average, you can make general predictions as to where the
price will go.
As we said, moving
averages smooth out price action. There are different types of moving
averages, and each of
them has their own level of “smoothness”. Generally, the smoother the
moving average, the
slower it is to react to the price movement. The choppier the moving
average, the quicker
it is to react to the price movement.
Simple Moving Average (SMA)
A simple moving
average 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.
If 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 your simple
moving average.
If you were to plot a
5 period simple moving average on a 10 minute chart, you would add up the
closing prices of the
last 50 minutes and then divide that number by 5.
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.
Most charting
packages will do all the calculations for you. The reason we just bored you
(yawn!) with how to
calculate a simple moving average is because it is important that you
understand how the
moving averages are calculated. If you understand how each moving average
is calculated, you
can make your own decision as to which type is better for you.
Just like any
indicator out there, moving averages operate with a delay. Because you are
taking
the averages of
the price, you are really only seeing a “forecast” of the future price and not
a
concrete view of the
future. Disclaimer: Moving averages will not turn you into Ms. Cleo the
psychic!
Here is an example of
how moving averages smooth out the price action.
On the previous
chart, you can see 3 different SMAs. As you can see, the longer the SMA period
is, the more it lags
behind the price. Notice how the 62 SMA is farther away from the current
price than the 30 and
5 SMA. This is because with the 62 SMA, you are adding up the closing
prices of the last 62
periods and dividing it by 62. The higher the number period you use, the
slower it is to react
to the price movement.
The SMA’s in this
chart show you the overall sentiment of the market at this point in time.
Instead of just
looking at the current price of the market, the moving averages give us a
broader
view, and we can now
make a general prediction of its future price.
Exponential Moving Average (EMA)
Although the simple
moving average is a great tool, there is one major flaw associated with it.
Simple moving
averages are very susceptible to spikes. Let me show you an example of what I
mean:
Let’s say we plot a 5
period SMA on the daily chart of the EUR/USD and the closing prices for
the last 5 days are
as follows:
Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving
average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5=
1.2358
Simple enough right?
Well what if Day 2’s
price was 1.2300? The result of the simple moving average would be a lot
lower and it would
give you the notion that the price was actually going down, when in reality,
Day 2 could have just
been a one time event (maybe interest rates decreasing).
The point I’m trying
to make is that sometimes the simple moving average might be too simple.
If only there was a
way that you could filter out these spikes so that you wouldn’t get the wrong
idea. Hmmmm…I wonder….Wait
a minute……Yep, there is a way!
It’s called the
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 Days 3-5, which means that the spike on
Day 2 would be of
lesser value and wouldn’t affect the moving average as much. What this does
is it puts more
emphasis on what traders are doing NOW.
When trading, it is
far more important to see what traders are doing now rather than what they
did last week or last
month.
Which is better: Simple or Exponential?
First, let’s start
with an exponential moving average. When you want a moving
average that will
respond to the price
action rather quickly, then a short period EMA is the best way to go. These
can help you catch
trends very early, which will result in higher profit. In fact, the earlier you
catch a trend, the
longer you can ride it and rake in those profits!
The downside to the
choppy moving average is that you might get faked out. Because the
moving average responds
so quickly to the price, you might think a trend is forming when in
actuality; it could
just be a price spike.
With a simple
moving average, the opposite is true. When you want a moving average that is
smoother and slower
to respond to price action, then a longer period SMA is the best way to go.
Although it is slow
to respond to the price action, it will save you from many fake outs. The
downside is that it
might delay you too long, and you might miss out on a good trade.
SMA EMA
Pros:
Displays
a smooth chart, which eliminates most
fakeouts.
Quick
moving, and is good at showing recent
price
swings.
Cons:
Slow
moving, which may cause a lag in buying
and
selling signals.
More
prone to cause fakeouts and give errant
signals.
So which one is
better? It’s really up to you to decide. Many traders plot several different
moving averages to
give them both sides of the story. They might use a longer period simple
moving average to
find out what the overall trend is, and then use a shorter period exponential
moving average to find a good time to
enter a trade.
Euro Exchange Rate
