Wednesday, January 6, 2010

How to use the Moving Average Indicator: Forex Trading

What are moving averages?

Moving averages are indicators of technical analysis used in Forex, which will help to identify trends to take the market over a period of time determined by the trader with the currency of their choice, taking as reference the average price currency. (Also known as MA). It's called “moving” because it always indicates which will be the average price of the current pair. Thus, the average is in constant motion, this will keep prices of the currencies in the market.

There are four types of moving averages:

• The simple moving average (SMA: Simple Moving Average): This is the average mentioned above, this has the characteristic that each day that passes, it eliminates the first day of the series in the calculation and adds the last day.

• The exponential moving average (EMA: Exponential Moving Average): Includes all historical data, applying a weighting exponential (the exponential average of the first day is the closing of that day). This average places priority on closing prices (current data) and less priority to older data. It is determined by the following formula:

Today’s Average = yesterday + (Today’s Close - Yesterday´s Average) x (2 / n +1)

• The weighted moving average (WMA: Weighted Moving Average). It gives priority to the most recent prices, so that recent prices have more influence than the former ones.

• The smoothed moving average: Assigns the same weight on past prices, but not to recent prices.

The big difference between the simple moving average and the last two indicators is that the moving average uses the same weight for each period and the EMA and WMA assign more value to the periods that are closer.

Using the moving average indicator to invest in Forex

It is important to first establish the time period you want to trade in Forex; you can take long periods of years or months or you may take periods of days and hours. But it is important to note that like any technical indicator, the time frame in which you trade is very important because it determines the probability of the success of a trade.In theory, if you trade in major timeframes, more exact your signals will be. In this case, while the shorter the time period moving average is it will be more sensitive to price changes but less robust. However if it provides long periods of time it will be less sensitive to price changes but also more solid.

For example, for you can determine the simple moving average of the USD/EUR over a period of 20 days. In that period the data collected of prices that has had this pair during this time and then it will divide it by the same number the period you set (in this case 20). When you determine the average, you will be able to identify trends in the market.

The common formula for calculating the moving average is:

The moving average is the result of the sum of the last N values of the price or price in the market, divided by N

Formula: μ=∑xi/n

• μ should be read as mu and it is the moving average we want to calculate.
• N is the period for which we calculate the moving average.
• Xi (where i takes different values from 1 to n) are n values of the share price in the N days considered.

Moving averages are also used to establish significant levels of support and resistance. The periods in this indicator that are more used to establish support and resistance levels are: SMA (50), SMA (100), SMA (200), EMA (144), EMA (89) and EMA (34).

How to read moving averages signals?

If the price is located above the moving average it is considered that the Forex market is in an uptrend. If the price is set below the moving average it is considered that the market has a downward trend. At the same time you can determine the strength of the trend by observing the pending of the moving average indicator. When there is no pending this means that the market has no specific trend.

You can observe buy and sell signals when there are crossings between short periods of moving averages with long periods in the direction of the market trend. So also when there is disruption of the moving average. This you can see it with more detail in the following graphic.

Moving averages give you signals:

• When 2 moving averages cross
• When there are breakouts in the moving averages

Now let's see it in the graphic:

1. To see the trend

For example, here we are using the moving average indicator to identify the trend. In this case we are using the rule's position in the market price in relation to the moving average.

• We see a 20 in yellow
• 100 in red
• 200 in blue

Here is an upward trend since the price is above the moving average.

The rule is: When price is above the moving average it will show an upward trend and on the other hand, when the market is below the moving average then it will follow a downtrend.

The following chart shows a downtrend, since the market is below the moving average.

2. When the averages are growing:

Other methods are for example when crossing moving averages may be an indication to buy or sell in the market

• We see yellow at 20
• In 100 red
• In 200 blue

When the yellow line crosses (short period to 20) with the line with the long-period moving average (200) it indicates that it activates the signal to sell.

When a short-period moving average (yellow line) goes down and crosses a long-period moving average (blue line) it activates the signal to sell.

When a short-period moving average (yellow line) goes up and crosses a long-period moving average (blue line) it activates a buying signal.

3. When used as support/resistance

The moving average can also be used as support/resistance, on the graph the level of support we see rejects the growing market that is approaching.

Remember that no investment is risk free and the moving average indicator in Forex will help you most effectively when used in conjunction with other tools.

If you would like to have more information please click here: Moving Average Indicator

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