Forex Technical Indicators: Moving Averages

Technical Indicators Basics

The term "technical indicators" refers to the mathematical (also known as quantitative) tools that are applied when using technical analysis. These technical indicators are derived from the mathematical processing of currency prices and various other characteristics of the movement of the forex market.

Generally, there are two basic groups of technical indicators: moving averages and oscillators. In this article we will closely examine the first group - moving averages.

Moving Average Basics

A moving average refers to the average price of the currency under consideration over a pre-determined number of time fragments, such as days, hours and etc., divided by that number of time fragments. Starting from the first regular time fragment, the averaged price is determined for each fragment included in the time period under consideration.

Thus, the statistical noises are eliminated from the moving average calculations, which results in a smoother line than the original line of the particular currency. This leads to a more convenient depiction of the currency activity and ease of use by forex traders. Moving averages have several applications. One of them is as a special separate indicator, whereas another is for the purpose of creating an oscillator.

Types of Moving Averages

There are three main types of moving averages that are applied in technical analysis:

• Simple Moving Average (SMA)

  It is also known as arithmetic mean. The SMA is calculated by adding the currency closing prices for a certain number of time periods and then dividing the sum by that number of time periods.

• Linear Weighted Moving Average (LMA)

  The more recent closing prices are given more weight under this type of moving average. In order to do this, the moving average is calculated by multiplying each of the closing prices prevalent over a given time period by its fixed position in the data series. Thus, the price prevalent during the last day is multiplied by one. Each closer day is multiplied by an increasing consecutive number. After that the prices are summed together and divided by the sum of the multipliers.

• Exponential Moving Average (EMA)

  It is also known as exponentially weighted moving average. This type of moving average is similar to a simple moving average, with the addition that more weight is given to the latest data.

How to Use Moving Averages

Moving averages provide forex traders with various signals.

1. One of the applications of moving averages is for determining entry or exit points.

   You should buy a currency pair on the forex market when:

   • The price increases and a closes above the moving average.
   • The underlying price chart is crossed from below up by the moving average chart.

   You should sell a currency pair when:

   • The price decreases and closes below the moving average.
   • The underlying price chart is crossed from above down by the moving average chart.

   For the purposes of technical analysis usually two or three moving averages charts are constructed for different time periods. These time periods can be long-term, short-term and middle-term.

   A forex trader should buy a position when:

   • In a combination of two moving averages, the shorter term of the two consecutive averages intersects the longer one in an upward direction.
   • In a combination of three moving averages, the short-term moving average intersects the middle-term and long-term moving averages upward. A confirmation of this buying signal is received when the long-term moving average is intersected by the middle-term average upward.

   A forex trader should sell a position when:

   • In a combination of two moving averages, the shorter term average is intersected by the longer term average in a downward direction.
   • In a combination of three moving averages, the short-term moving average intersects the middle-term and long-term moving averages downward. A confirmation of this selling signal is received when the middle-term moving average also intersects the long-term moving average downward.
2. Another application of moving averages is the determination of the strength of a trend by examination of their slopes.
   • If the slope of the moving average is steep, then the strength of the trend is high. On the other hand, if the slope of the moving average is flat, than the strength of the trend is lower.
   • A slope with an upward direction implies an increasing currency. On the other hand, if the slope is with a downward direction, then the currency is decreasing.
3. Another application of moving averages is determining of a support or resistance levels. Traders often look at moving averages as points of resistance or support.

The wide use of moving averages requires you to get well acquainted with their meaning in order to make more successful trading decisions.

Moving Average Envelope

Another strategy for applying moving averages for the purposes of technical analysis is the so called moving average envelope. This strategy involves two additional bands around a moving average that are shifted in either direction by a particular percentage, which is fixed in value.

Those additional bands are calculated in the following way:

Upper band = Moving Average x (1 + K)

Lower band = Moving Average x (1 - K)

Where K is the chosen moving average envelope percentage.

The moving average envelopes can be very useful in identifying overbought or oversold conditions.

However, you should remember that moving averages should be combined with other indicators in order to get a more accurate picture of trading levels.

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