Price smoothing

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.