PIP ACADEMY
The Ultimate Path to Trading
Length : 7.00 Minutes
Moving Averages (MA)
The moving average is a famous indicator in technical analysis that helps to smooth out price fluctuations and short term noises in the market. They are used to emphasise the direction of a trend.
Moving averages create a more clear picture for interpretation of market condition that, whether the market is trending, consolidating or facing a trend reversal by filtering the short term noises and fluctuations.
Since the moving average is based on past prices, it is considered a lagging indicator.
The MA is constructed by calculating a simple average of the closing price of a currency pair over a defined number of time periods.
For example, a 14 day period moving average adds the closing price of a currency pair for the past 14 consecutive days and divides the result by 14 each day. On the next day, once a new closing price data is added the oldest closing price will be out of the equation.
There are many different types of moving averages, which they have different level of smoothness. The two most commonly used moving averages are the exponential moving average (EMA) and the simple moving average (SMA).
The exponential moving average, place a higher weighting on the recent data, thus it is considered more reactive to the latest price fluctuations than the simple moving averages, which weights all the closing price data the same.
As a result, that makes EMAs more timely and less laggy than SMAs. Simple moving average will take longer time compared to the exponential moving average to signal the beginning of a trend in the market, specially when there is a price breakout from a price consolidation pattern.
The smoother the moving average, the slower it is to signal and react to the changes in the market condition.
The longer is the period in the calculation of the moving average, the smoother is the moving average as they are more older data points included in the calculation.
To put it differently, a moving average that takes a shorter period in its calculation reacts faster to the changes in the market, and conversely a moving average that has a longer period in its calculation reacts slower to the changes in the market and it is considered smoother.
Let’s take a look at the two moving averages below for a better illustration.
The two windows above are the settings for the two different moving averages selected in the Metatrader platform. The one on the left has 200 selected as the period and the one on the right has 14 selected as the period. The 200-period moving average, which is in yellow colour will consider the closing price of the currency pair for the past 200 days for the calculation.
On the other hand, the 14-period moving average, which is in red colour will take only 14 days of the closing price for the calculation.
Both of these moving averages have been placed in the chart below. As you can see the 200-period moving average is way smoother and slower in regard to the changes in the market than the 14-period moving average. As a result, the 14-period moving average follows the market price closely and it is more responsive and sensitive to the price fluctuation.
Moving Average is A Dynamic Support/Resistance
Moving averages just like trend-lines are considered as a dynamic level of support and resistance. Once the price of a currency pair crosses and moves above the MA, the moving average will serve as a dynamic support level.
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Conversely, once the price crosses below the moving average, the moving average will be considered as a dynamic resistance level.
Moving Average Characteristics
Generally speaking, A raising moving average signals a rising trend and a falling moving average signals a falling trend. The sharper the slope of the MA, the greater is the bearishness and bullishness of the trend.
In addition, Moving averages also signal the changes in the price trend once the price crosses the moving average, rather than only by a reversal in the direction of the moving average. For instance, when the price drops below the moving average that could be interpreted as a formation of a bearish trend in the market.
On the other hand, when the price rises above the moving average that could be interpreted as a formation of a bullish trend in the market.
However, it is important to note that moving averages produce many false signals just like any other indicators. For example, according to the daily GBP/USD chart below a sudden rise of the price above the 200-period moving average could be considered as a start of a bullish move, however as it can be seen it was only a false break-out and the market started to bounce back and continue its bearish move.
Thus, for a better quality of the signals, it is better to get confirmation both from the MA direction and also the price crossover. For example, when the Ma is falling, the price has to be below the MA as well.
It is important to use the MA in conjunction with other indicators and technical tools to improve the overall trading performance.
A carefully tuned Moving Average should reflect the underlying trend in the market. In fact, one has to continuously tune and monitor the moving average to assure that it stays relevant to the latest market condition. The violation of the MA by the market price or change in its direction that could signal a reversal in the price trend, should be accompanied by other indicators and technical tools for confirmation.
Generally the longer the time period of the MA, the greater is the significance of a crossover signal.
For instance, a 200-day moving average violation is substantially more important than a 14-day moving average crossover.
Moreover, reversal in the direction of the MA is usually a stronger signal of a reversal in the market than a crosser.
It is important to note, that there is no perfect Moving Average setting and there is a trade off between the sensitivity and the time-span of the MA. Smoother MAs (Longer period MAs) are slow to signal changes in the market trend, but at the same time they generate less false signals. On the other hand, the sharper (Shorter period MAs) are more adaptive and faster to signal changes in the market trend, but in return they generate more fake signals and whipsaws.
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Multiple MAs strategy
Multiple MAs strategy is one of the effective technical strategy for trend determination, which involves more than one MAs. Usually, two MAs with two different period, one lower than the other is plotted on the graph. Signals are give by a shorter-term MA crossing above or below a longer-term MA. Such a strategy could help to reduce the amount of fake signals produced by a single MA significantly. This procedures create an advantage to smooth the data twice, to eliminate the potential fake signals but also signals the trend reversal and changes in the market fairly quickly.
In the chart below, two MAs with two different period has been plotted. The red MA is a shorter period and is more sensitive. The yellow one is a longer period MA and is less sensitive. The bullish signal is created once the red crosses above the yellow one, and the bearish signal is given once the red crosses below the yellow one.
Summary
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1) The longer is the period in the calculation of the moving average, the smoother is the moving average. The smoother the moving average, the slower it is to signal and react to the changes in the market condition, and the less it generates false signals.
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2) The Shorter is the period in the calculation of the moving average, the more sensitive is the moving average. The more sensitive the moving average, the faster it is to signal and react to the changes in the market condition, and the more it generates false signals.
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3) Once the price of a currency pair crosses and moves above the MA, the moving average will serve as a dynamic support level. Conversely, once the price crosses below the moving average, the moving average will be considered as a dynamic resistance level.
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4) A raising moving average signals a rising trend and a falling moving average signals a falling trend. The sharper the slope of the MA, the greater is the bearishness and bullishness of the trend.
5) When the price rises (falls) above (below) the moving average that could be interpreted as a formation of a bullish (Bearish) trend in the market.
6) For a better quality of the signals, it is better to get confirmation both from the MA direction and also the price crossover.
7) Reversal in the direction of the MA is usually a stronger signal for a reversal in the market than a crosser.
8) Multiple MAs strategy is constructed by plotting a shorter term MA together with a longer term MA.
9) Multiple MA strategy could help to reduce the amount of fake signals produced by a single MA significantly.