What is a moving average?
The moving averages are undoubtedly the technical indicators most commonly used by investors but require a good understanding of their operation and interpretation.
A moving average corresponds in reality to the average price of an asset over a defined time period. It is calculated from several elements such as the opening price, the closing price, the highest price level and the lowest price level attained for each time unit.
The most popular moving average is that which uses the closing price. It indicates the average price at which an asset has closed during the time period concerned.
The term ‘moving’ here indicates that this average changes with each particular time unit. This calculation is made by integrating the price at the last time unit and removing the oldest price from the chart.
Another point, we can differentiate between the simple moving averages and the weighty moving averages that give more importance to certain prices.
How to use moving averages when trading:
The moving averages are often supplied directly by the trading platforms and are generally displayed in the form of continuous lines on a chart. However, to use them there are two main methods:
The most popular method uses the crossover points between the moving averages and the prices. When the price goes above the moving average and rises, this can be interpreted as a buy signal. To the contrary, when the price line falls after crossing below the moving averages line then this can be interpreted as a sell signal.
Another, less popular but more effective, method consists of using the crossover points of two moving averages against each other. The first of these two moving averages concerns the short term and the second a longer term. When the short moving average rises above the long moving average this indicates a buy signal. And, on the contrary, when the short moving average falls below the long moving average this may be interpreted as a sell signal.
These two techniques of analysis and interpretation of moving averages therefore enable you to react in the trend direction and identify the pertinent buy and sell signals.
Simple moving average and exponential moving average
The moving average shows the average value of an asset price over a set period. Therefore, moving averages can predict possible future fluctuations in the prices.
Calculating a simple moving average breaks down to calculating the arithmetic average of the closing price of the currency pair from several defined periods.
Using an analysis of 10 periods with a daily rate, we obtain the moving average by adding the closing prices of this pair over the last ten days and dividing by the number of the periods defined above, which is 10. Then, we make the same calculation for each new period. From the tenth period we will be able to predict the precise moving average.
This moving average is represented on a chart with a continuous line layered over the classic chart.
Therefore, this simple moving average enables us to understand the consensus of the different expectations that occurred during earlier periods.
If there is a price above the simple moving average, this means that the current expectations are higher than the average of the previous expectations. The place indicated by the cross between the moving average and the crossover will represent an important indicator called the “buy signal”. It is therefore an efficient indicator but it also has its limitations. Indeed, the fact of waiting for a buy signal or a sell signal to perform an action, can lead to a belated positioning in the market, especially over short periods.
In the market, we can find software that enables us to automatically detect these “buy” and “sell” signals. Use them as a supplement to your normal trading platform.
Concerning the observation of long-term trends, the moving average may prove to be a great way to analyse data so as to simplify a chart. It shows here the movement trends for the currency pair rate treated over a long period. In this particular case, a reversal in the trend (the curve changes dramatically in its inclination) sends you a signal that proves to be a great way to earn substantial profits at the moment you show reactivity and attention.
Regarding exponential moving averages, we can say that they correspond to the weighted average of the closing prices of these periods ‘X’. They therefore give an equal importance to these different closing prices.
The principle here is to assign different coefficients depending on whether the closing prices are old or new. The older the closing price is, the larger will be its coefficient and vice-versa. The only choice to make here is the choice in the type of weighting that will be applied.
Here we have the methodology to be applied: We have to decide the value in weight (p1) that we will assign to the day’s closing rate. The rest, expressed as a percentage, represents then the following formula: p2=100-p1. We have to multiply these results by the exponential moving average of the previous period and we then add the two results. By doing this, we obtain the exponential moving average.
How do we establish the percentage p1? In order to precisely determine your calculation, you should establish this percentage according to the following formula: p1=p2/(periods+1).
For a two day period, this formula will therefore be: p1=2/(2+1) that is 2/3. P1 here is equal to 0, 66666, we should therefore apply a percentage of 66%.
This result enables us to predict the percentage we have to apply to the exponential moving average of the previous day, which will be: 1-0, 66, that is 0.34, therefore 34%.
With this information, we can deduce that the exponential moving average is equal to:
0.66 closing + 0.4 X exponential moving average of the previous period.
The example used here is called an exponential moving average for two days. In fact, many traders often use the number of the periods in the calculation of their exponential moving average.
The different information you can extract from this calculation is noticeably the same as the one from the simple moving average, however, the first one will be more accurate. You are free to choose the calculation you prefer depending on the importance you will give to the past information.