From babypips.com
Two major types of moving averages: 1. Simple
2. Exponential
Simple Moving Averages
The SMAs in this chart show you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.
Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average and it's that they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new trend may be developing but in reality, nothing changed. Exponential moving average to avoid this problem.
Exponential moving average
Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.
This would mean that the spike on Day 2 would be of lesser value and wouldn't have as big an effect on the moving average as it would if we had calculated for a simple moving average.
If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders are doing recently.
Let's take a look at the 4-hour chart of USD/JPY to highlight how an SMA and EMA would look side by side on a chart.
Notice how the red line (the 30 EMA) seems to be closer price than the blue line (the 30 SMA). This means that it more accurately represents recent price action. You can probably guess why this happens.
It's because the EMA places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing NOW rather what they were doing last week or last month.
Below is a table to help you remember the pros and cons of each.
| SMA | EMA | |
|---|---|---|
| Pros | Displays a smooth chart which eliminates most fakeouts. | Quick Moving and is good at showing recent price swings. |
| Cons | Slow moving, which may cause a a lag in buying and selling signals | More prone to cause fakeouts and give errant signals. |
So which one is better?
It's really up to you to decide.
Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.
Using Moving Average
One sweet way to use moving averages is to help you determine the trend.
If price action tends to stay below the moving average, then it would indicate that it is in a downtrend.
The problem with this is that it's too simplistic. What some traders do - and what we suggest you do as well - is that they plot a couple of moving averages on their charts instead of just one. This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.
In an uptrend, the "faster" moving average should be above the "slower" moving average and for a downtrend, vice versa. For example, let's say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:
Moving Averages Crossover Trading
You know how to determine the trend by plotting on some moving averages on your charts. You should also know that moving averages can help you determine when a trend is about to end and reverse.
Let's take another look at that daily chart of USD/JPY to help explain moving average crossover trading.
From around April to July, the pair was in a nice uptrend. It topped out at around 124.00, before slowly heading down. In the middle of July, we see that the 10 SMA crossed below the 20 SMA. One thing to take note of with a crossover system is that while they work beautifully in a volatile and/or trending environment, they don't work so well when price is ranging.
It looks like it held really well! Every time price approached 50 EMA and tested it, it acted as resistance and price bounced back down. One thing you should keep in mind is that these are just like your normal support and resistance lines.
This means that price won't always bounce perfectly from the moving average. Sometimes it will go past it a little bit before heading back in the direction of the trend.
From the chart above, you see that price went slightly past the 10 EMA a few pips, but proceeded to drop afterwards. There are some traders who use intraday strategies just like this. The idea is that just like your horizontal support and resistance areas, these moving averages should be treated like zones or areas of interest.
The area between moving averages could therefore be looked upon as a zone of support or resistance.
