Moving average is yet another indicator used in forex trading to forecast the next price movements. The word "average" already points to the main idea behind the moving average indicator – to show the average value of the price changes. In other words, moving average "flattens" out the price slop over a certain set of values.
There are several types of moving averages and for each type there is a unique way of calculating the average. We will be talking about 2 major moving average types:
1. Simple Moving Average (shortly SMA)
2. Exponential Moving Average (shortly EMA)
Simple Moving Average – SMA
Simple (also referred to as Arithmetical) Moving Average is the simplest type and most popular one among forex traders.
Let's go back to your high school days and recall how average is calculated in the first place. It's simple – you add up all the numbers together and divide it by amount of numbers. Allow us to give an example! The class average of final exam scores (for a very small class of 5 students!) is calculated below:
Maria's score = 70
Daniel's score = 85
Michelle's score = 97 (an A student!)
Marcus's score = 72
Christopher's score = 60
The sum of all scores is 70+85+97+72+60 = 384
The average score of the class is 384 divided by amount of scores: 384 / 5 = 76.8
The same thing is done for simple moving average – you sum up all the prices, lets say 60 closing prices for the last two months (60 days). Then you divide the result by 60 (amount of closing prices) and Voila! There you have your moving average.
Why are we wasting your time on this when most forex broker platforms calculate this for you? Well, it won't hurt to actually understand how things work.
There is of course a delay when it comes to calculating moving average. The predictions you make with this indicator doesn't show you a definite glimpse of the future price movements. It is only a forecast – a general prediction of the future price, so don't tell all of your friends that you are a true psychic yet!
Sometimes Simple Moving Average is just… how should we put it… too simple! There is a huge flaw in simple moving average indicator and it is called "spikes".
Let's consider an example – the agenda is to calculate SMA using a daily chart for a particular currency pair and the closing prices for the last 5 days are listed below:
1.4533
1.4537
1.4540
1.4543
1.4550
The sum of all closing prices is 7.2703
The average (SMA) is 7.2703 divided by 5 equals to 1.4540
So what is the problem with simple moving average then??
What if the second closing price isn't 1.4537… What if the closing price is suddenly very low… what IF it is 1.4500?? The simple moving average result would be much lower and your forecast would indicate that the price is moving down, when in fact the movement is just a bit "spiky" but overall price movement is going up.
So what is the solution to this average mess?! That's when Exponential Moving Average comes in handy.
Exponential Moving Average indicator "flattens" Moving Average. How is it calculated? You add moving average of the current closing price to moving average of the previous closing price. And don't forget that the last prices get more weighted value.
So, for example, the "spiky" price movement that we have got because of 1.4500 closing price on a second day will not be so important.
Now the big question arrives – which one of the two moving average indicators is better? Lots of forex traders actually use both types to get a better view, so it is entirely up to you which type to use.
So the trading tip for today is "practice, practice and practice some more!" Get some charts and do your homework. Sooner or later you will find which moving average indicator works best for you.