Moving Average Trading Strategy – A Basic Study

Traders usually finalize their position after analyzing a currency pair through various angles. One such angle is moving average which is basically a strategy used to check the movement of the price for a particular time. The price of any currency pair is highly volatile in a short term which makes it difficult to analyze where the price is actually heading. This is where moving average comes into play as the traders use to identify the direction of a trend.

Moving average can be calculated for any number of days or months or weeks or even year. This is the average price of currency over a particular time. The best part is you don’t have to calculate anything as this is done automatically by the modern day charts. Suppose, you are looking for a 50 day moving average of a particular currency; the chart will add up the closing price of last 50 days and divide it by 50 giving you a smooth data of moving average. The following figure shows an example of the moving average:

For a shorter period, the price movement is analyzed closely and that is why the data is sensitive unlike a chart of a long period where the data is less sensitive and therefore the graph will be more smoothed out.

Mostly the forex traders prefer checking the intraday (within a day) moving average. Suppose you are analyzing a 10-minute chart and want to analyze the 5-period simple moving average. To calculate this, you just need to take the prices in the past 50 minutes (Calculated by multiplying 10 by 5) and divide it by 5.

Again, suppose you want to analyze the 5-period simple moving average on a 1 hr chart, then you simply need to calculate the closing price of last 5 hrs (1hr x 5-period = 5 hrs).

There is no strict rule to analyze the moving average. It all depends on a personal preference so you must experiment with different periods and choose the best that suits you.

Why are Moving Averages Popular?

Moving averages are popular as it is a highly effective way to plan the next position. A trader can easily recognize the corrective, ranging and trending environments to open or close the position. They analyze the moving average of different periods such a 15 day, 50 day, 6 months, etc to make out the actual trend.

Types of Moving Average

There are two types of moving average:

  • Exponential Moving Average (EMA)
  • Simple Moving Average (SMA)

What we discussed above was a simple moving average in which the fixed periods are taken for calculations with each period equally weighted. A drawback of this calculation is that the average price is highly affected by large price movement especially when checked in short-term. Suppose, you are checking a ten-day moving average of a currency pair USD/EUR and the price is going up. Then one day the price spikes down showing that the trend is going down, but that downward movement of the price is caused by something which is not likely to happen again in the near future.

This problem is solved by the exponential moving average. Unlike SMA, EMA does not give equal weightage to the closing price of all days. Instead, it gives a higher weightage to the price occurring at the end days. Suppose in the case of a five-day period, weightage is given to the prices on the 3rd, 4th and 5th day. So, if in case there is a big movement on day one and two, the average price will not be affected as much as SMA.

Let’s take an example to understand moving averages:

Suppose, following are the closing price of EUR/USD:

Day 1: 1.0931

Day 2: 1.0975

Day 3: 1.1082

Day 4: 1.1159

Day 5: 1.1103

Now, to calculate the SMA we will just add these five figures and divide it by 5.

(1.0931 + 1.0975 + 1.1082 + 1.1159 + 1.1103)/5 = 1.1050

Now suppose some economic event happened and euro falls .0131 points the second day. So the new closing price of EUR/USD for the 2nd day would be 1.0800. So let’s see the effect:

Day 1: 1.0931

Day 2: 1.0800

Day 3: 1.1082

Day 4: 1.1159

Day 5: 1.1103

The new SMA would be:

(1.0931 + 1.0800 + 1.1082 + 1.1159 + 1.1103)/5 = 1.1015

See how different the results are. A small economic report showed that the trend has changed. This is not actually a trusted data as the fall is just for a day which is not going to happen again.

When calculating EMA the last three days are given more weightage and hence the calculation becomes different and so the average moving price which can be better trusted as the movement of day 2 is not affecting the overall average.

Don’t worry; it is not your part to go into deep calculations to calculate the SMA and EMA. The charts will do this for you, but you should have an idea about how the things work. It all depends on the experience of the trader how he wants to analyze the chart, whether with SMA or EMA. Experiment with both and pick out what works best for you.

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