Moving averages are amongst the most widely used tools by participants in the currency markets. The strength of a moving average is its ability to filter out price noise reducing what can be extremely volatile price series into more discernible trends, thereby allowing traders to ascertain the strength and direction of the trend. Moving averages smooth past price data to form trend following indicators and are a component in many other technical indicators including the MACD, the DeMarker and the Directional Movement System amongst many others.
A number of widely used indicators, including the Relative Strength Index (RSI), Average True Range (ATR) and the Directional Movement Index were developed by J. Welles Wilder and introduced in his 1978 book, “ New Concepts in Technical Trading Systems”. Wilder uses a variation of the standard Exponential Moving Average formula, which has a significant impact when choosing suitable time periods for his indicators.
EMA formula = price today * K + EMA yesterday * (1-K) where K = 2 / (N+1)
Wilder EMA formula = price today * K + EMA yesterday (1-K) where K =1/N
Where N = the number of periods.
Trading with Moving Averages
Type to use
Moving averages are commonly used to identify trends and reversals as well as identifying support and resistance levels. Moving averages such the WMA and EMA, which are more sensitive to recent prices (experience less lag with price) will turn before an SMA. They are therefore more suitable for dynamic trades, which are reactive to short term price movements. Moving averages such as the SMA move more slowly providing valuable information on the long dominant trend. They can however be prone to giving late signals causing the trader to miss significant parts of the price movement.
Moving Average Crossovers: Moving average crossovers is a term applied when more than one moving average is used to generate a trade signal where traders will act when the shorter term moving average crosses the longer term moving average. A bullish crossover occurs when the shorter term moving average crosses above the longer term moving average (golden cross). A bearish crossover occurs where the shorter term moving average crosses below the longer term moving average (dead cross).
Price crossovers: A Price crossover is a term applied when a signal is generated where the price crosses a moving average. Bullish signals are given when the price moves above the moving average, bearish signals are given when the price moves below the moving average. Crossover trades are more likely to enjoy success when the moving average slopes are in the direction of the trade.
Support and Resistance: Moving averages can also act as a support level in an uptrend and resistance levels in a downtrend. If the average is widely followed orders in favour of the trend often cluster around the average. As markets are often driven by emotion and many players trade counter to the trend expect overshoots, to this extent the average should be used to identify support and resistance zones rather than exact levels.