What are Moving Averages?

Moving averages are technical tools of analysis and are a must-have for every trader. They are trend indicators and help narrow down the fluctuations in the market, thus simplifying the trading process and allowing you to make a successful trade.

Traders mainly use moving averages to smooth out cost fluctuations, differentiating between typical market noise and an actual market trend path. In moving averages, the trader sums up the average closing price of a currency pair over a specific period and divides it by the number of data points, giving you an average. This recurring calculation is usually based on the latest price data, hence the name, moving average.

Traders and analysts evaluate an asset’s price by using moving averages to study support and resistance movement in the market. This information is essential in determining the potential path of the asset cost. It is also known as a lagging indicator as it trails the asset’s price action by producing a signal by creating a sign showing the direction of the trend.

There are several types of moving averages that analysts and traders use, but the most common ones include:

1. Simple Moving Averages

This is the most straightforward technical tool for calculating moving averages. You can obtain a moving average of an asset by summing up the most recent data point and dividing it by the total number of prices in the set. The Simple Moving Average helps generate signals that indicate the best time to enter or exit the market. It is a backward-looking analysis as it relies on past price data.

In financial markets, investors use simple moving averages to determine buy and sell signals for assets and securities. It also helps them identify support and resistance signals, crucial indicators of when to enter or exit a trade.

The formula for calculating a simple moving average is:

​SMA = A1+A2+….+AN/n

  1. Average in period n

n- Number of time periods

For instance, Maple, a stock trader, wants to calculate a simple moving average for asset BRAKE by assessing the closing prices for the past five days. The assets’ price for the past five days is as follows: $30, $30.50, $30.30, $31, and $33.40. The SMA for BRAKE is calculated as below:

SMA= ($30 + $30.50 + $30.30 + $31 + $33.40)/5

SMA= $31.04

2. Exponential Moving Average

This is a more complicated moving average tool that utilizes recent prices to determine market trends. The exponential moving average is more suited to recent prices changes as the data collected is more responsive to current data points.

How to calculate EMA;

Follow the steps below when calculating the exponential moving average

  1. First, you will have to calculate the simple moving average for the previous period’s EMA. This is done by obtaining the summation of the asset or security prices for the period you need, then dividing it by a number of sets.
  2. Next, calculate the multiples for weighing the EMA. This is also referred to as the smoothing factor, whose formula is as follows:

2/ (selected time periods +1). For instance, if you are calculating for a 30-day moving average, then the smoothing factor would be calculated as follows

Multiplier = 2/ (30+1)= 0.0645

  1. Then calculate the current exponential moving average by taking the period from the initial EMA to the most recent, using the price, multiplier, and the previous EMA. The formula for calculating the current EMA is as follows:

EMA = {Closing price – EMA (previous time period)} x Multiplier + EMA (previous time period)

        EMAt= {Vtx (s/1+d)} + EMAYx {1- s/1+d)}

EMAt – Current EMA

Vt – Value today

EMAy – EMA yesterday

S – Smoothing

D – Number of days

Simple Moving Average vs. Exponential Moving Average

Although both are used to calculate the market’s price direction, the main variation is sensitivity to price changes. The exponential moving average is more sensitive to recent price changes; thus, it responds faster to changes in prices than SMA.

The formula for calculating SMA is simple and easy for beginners. On the other hand, the formula for calculating EMA is complicated and most suitable for experienced traders, analysts, and investors. However, the charting tools make it more convenient for traders to calculate, making it the most effective analysis tool.

Why Should You Use Moving Averages

Traders and analysts use a moving average to capture average changes in the prices of assets and securities in the market over time. For instance, an upward moving average might indicate an upswing in the price of a security. At the same time, a downward moving average might signify a decline in prices. There are various types of moving averages, and they range from simple to complex, therefore when choosing, ensure that you can successfully use it to avoid making losses.

Moving Average Length

Many traders prefer to use a moving average length of 10, 20, 50, or 100. However, the length depends on the trader’s time zone. And the best part is that it can be applied to any chart timeframe, whether minutes, days or weeks.

The length you choose determines your moving average effectiveness. A short time frame reacts quicker to price changes as it does not have a long look-back period. Therefore, a short time frame is better if you are a short-term trader as it produces less lag. In contrast, a long-term trader is more suited to more extended time frames.

Risk Warning

High-Risk Investment Warning: Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange, you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment, and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading and seek advice from an independent financial adviser if you have any doubts.

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