If I were restricted to only one indicator other than candlesticks, I would chose moving averages. I am not alone in that regard since many traders have expressed similar sentiment. Indeed, a majority of traders believe moving averages are an indispensable tool for recognizing underlying trends.
Full disclosure: After moving averages, Bollinger Bands would probably be my second choice for an indicator, and Fibonacci would be my third. There are some similarities between the 3 indicators. Indeed, Bollinger Bands as well as Fibonacci can be classified as “moving averages” though they function differently.
Moving averages are calculated by using the average closing price for a specific period, and using a line to display the information on a chart. The averages adjust with price activity but are based upon historical data.
There are 3 main types of Moving Averages that forex traders use:
Simple Moving Average
(SMA) is figured by adding a constant number of price values, where the value of the constant is known and dividing the result by the same value of the constant. The most widely used simple moving averages used in currency trading are the 5 day, 20 day, 50 day, 100 day and 200 day moving averages. Moving averages coincide to the period displayed on the charts, but generally, the daily charts are ones traders tend to rely on. The 200 day moving average is considered to be the most “accurate” as price action is smoothed out over a longer period, and trends can be deciphered more clearly, as much of the market “noise-” false signals, short term spikes, etc., is filtered out. On the other hand, the main drawback with the SMA is that it is lagging-even more so than other averages-and trends can be underway before they can be spotted on charts using this average. Many traders will add different types of averages with differing periods to compensate.
Exponential Moving Average
(EMA) is similar to a simple moving average, though this average emphasizes recent prices (increases exponentially), making it more responsive to changes in price direction. The disadvantage of this moving average is that it is not smoothed in the same way as the simple moving average, and is more affected by market noise. Many traders however, find this average quite useful in trading shorter time periods as it reacts much quicker with considerably less lag. This can be critical for certain scalping and intraday trading strategies.
Weighted Moving Average
(WMA and LWMA) and Linear Weighted Moving Average place a weighting factor to each value in the data points according to its age. Even more so than with the Exponential Moving Average, recent data enjoys greater weight in the WMA. Older data receives declining weight the further back we go, though there is a linear progression factor that closing prices are multiplied by. WMA is less widely used than SMA and EMA. Like the EMA, it was designed to reduce the lagging effect of simple moving averages. Best used in conjunction with simple moving averages, where the WMA can act as confirmation, especially when both averages move in same direction.
Other Moving Averages
There are more esoteric moving averages that some traders use including Adaptive, Elastic Volume Weighted, Endpoint, Indicator Adjusted Average, Indicator Weighted Average, Least Square, Mesa Adaptive, Modified, Sine Weighted, Triangular, Triple Smoothing, and Welles Wilder. While some are applied more often to equities and commodities trading-including gold (XAU) and silver (XAG), some traders use these on currency charts. However, they tend to have a bit more noise than the main indicators, and were designed primarily as options and variations for smoothing data.
How to Use Moving Averages?
Moving averages can be useful in determining trends, as well as support and resistance levels. Though price action will often move beyond exact points of moving averages, they are generally areas where price activity will congest or coagulate. This can be used to help identify entry as well as exit areas (rather than points or prices), especially when used in conjunction with other indicators, particularly those that measure momentum or strength of trend.
Moving Average Crossovers
One entry method traders employ, is when shorter term moving averages cross over longer term moving averages. A shorter term average crossing above and through a longer term one, is said to be a bullish signal, often referred to as a “golden cross.” A bearish crossover is the opposite. Here, a shorter term moving average crosses and moves below the longer term average. This is often referred to as a “dead cross.”
Note: one of the traits of ranging, consolidating or indecisive markets is when a “braiding” effect of moving averages can be seen on the chart. This means that the prices cross and recross each other in both bullish and bearish patterns resembling a DNA sequence. Before entering, some more risk averse traders will wait for a large gap to appear between the moving averages, after the crossover has occurred.
For many traders, an entry signal is generated when the price crosses a moving average, particularly the all important 200 day moving average. It is considered bullish when the price moves above the moving average, and bearish signals when price moves below the moving average. Traders will also use the moving average for exits when prices move above or below the moving average for an extended period or a certain distance confirmed by angular or horizontal trend lines. While moving averages are trend lines to a certain degree, confirmation is always helpful to prevent premature exits or entries.