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Types of Moving Averages and How to Use Them in Forex Trading

Learn about the different types of Moving Averages and how to use them to trade forex


Hello to all. We can say that the most profitable business in the world is trading in financial markets, of course, if one is successful. When trading in financial markets, encountering both gains and losses is inherent to the nature of the market. Experienced traders manage to minimize risks and develop their own unique trading strategies. In other words, everyone should find their own unique approach to trading in the market. This is where technical analysis comes to the forefront. In technical analysis, there are different methods to predict price movements. One of these widely used methods is technical indicators. Technical indicators do not behave emotionally unlike humans, which is why they are preferred by many. In this article, we will focus on the Moving Average indicator.

What is the Moving Average?

The Moving Average is one of the most preferred and widely used technical analysis indicators in financial markets for determining trends. Moving averages are favored by almost everyone who trades in the market due to their simple and easily understandable structure. They are known as trend-following indicators because they provide a guide as to where prices may be heading in the market. Essentially, their purpose is to smooth out fluctuations in a data series by calculating the average of data over a specific period. This makes trends and patterns in the data more apparent and sometimes reduces noise. Moving Averages can be used not only to identify trends when analyzing price movements in financial markets but also to define support and resistance levels and generate entry and exit signals. Additionally, Moving Averages provide data for many other technical indicators used in financial markets, such as MACD, RSI, PSAR, and Bollinger Bands.

Types of Moving Averages

We typically use Moving Averages to analyze price movements in financial markets. In Forex and stock markets, you can encounter various types of moving averages. The most commonly used and widely known main types of moving averages include the following:

  1. Simple Moving Average (SMA)
  2. Exponential Moving Average (EMA)
  3. Weighted Moving Average (WMA)

Now, let's take these one by one.

Simple Moving Average (SMA)

SMA is a basic moving average obtained by calculating the average of a financial asset's price movements over a specific period (e.g., 10 days, 20 days, 50 days, or 200 days). For example, a 10-day SMA calculates the average of the closing prices for the past 10 days. This period represents the data within a given time frame. SMA can be considered a statistical indicator used in various financial analysis and time series data analysis contexts.

Calculation. The calculation of the Simple Moving Average (SMA) is quite easy. The basic formula used to calculate SMA is as follows:

     SMA = (P1 + P2 + P3 + ... + Pn) / n

Here: SMA represents the Simple Moving Average. P1, P2, P3, ..., Pn represent each data point (e.g., closing prices) for a specific period. "n" indicates the length of the period used. When each new data point arrives, the oldest data point used in the SMA calculation period is subtracted, and the new data point is added, thus continuously updating the SMA. This allows the SMA to track changes in trends and movements within the data series.

How to Trade. SMA helps us see trends more easily by reducing the impact of small fluctuations in the data series. If the SMA of a stock or another financial asset is gradually rising, it indicates an uptrend. Conversely, if the SMA is declining, it signals a downtrend. In addition, SMA can be used to identify support and resistance levels. If prices move near the SMA for a specific period, it can function as a support and resistance level. If the short-term SMA crosses above the long-term SMA from below, we enter a Buy order. Conversely, if it crosses from above to below, we enter a Sell order. In the example below on the AUD/USD chart, you can see Buy/Sell orders being triggered and identified support/resistance levels when the short-term SMA (SMA 20) crosses the long-term SMA (SMA 50):

Forex trading and support/resistance levels with short and long-term SMA crossovers
Trading with short and long-term SMAs on AUD/USD chart

In the chart above, the short-term SMA (SMA 20) is represented by the blue line, while the long-term SMA (SMA 50) is represented by the orange line. However, you can customize these colors through the indicator settings if you prefer different colors. Additionally, you can adjust the input settings of the indicator to change the short-term SMA to 5, 9, 10, etc., and the long-term SMA to 100, 200, etc. In other words, you can set it to fit your own strategy. As the periods of SMAs increase, they smooth out market fluctuations, but they also exhibit lag in reflecting the current direction. When the short-term moving average crosses above the long-term moving average, it is called a 'golden cross' signal. When it crosses below the long-term moving average, it is called a 'death cross' signal.

Exponential Moving Average (EMA)

EMA is a type of moving average that assigns weight to each data point. EMA is different from SMA in terms of its calculation method. EMA gives more weight to recent data, making it react faster. This allows it to reflect recent price movements and data more quickly compared to SMA. EMA is particularly preferred in short-term analyses and situations where there is a need to detect trend changes more quickly.

Calculation. The initial value is determined. The first EMA value typically starts with an SMA and is considered the first data point. The formula used to calculate EMA is as follows:

     EMA(t) = [K x (P(t) - EMA(t-1))] + EMA(t-1)

Here: EMA(t) represents the EMA at time "t." P(t) represents the data at time "t" (e.g., closing price). EMA(t-1) represents the EMA at time "t-1." K is a constant that determines the smoothing factor of EMA and is usually calculated using the following formula: K = 2 / (n + 1), where "n" represents the length of the EMA period.

How to Trade. Trading using EMA in financial markets is similar to SMA. In other words, if the short-term EMA crosses above the long-term EMA from below, it's a buy signal. Conversely, if the short-term EMA crosses below the long-term EMA from above, it's a sell signal. Look at the example in the EUR/CHF chart:

Forex trading with the intersection of short- and long-term exponential moving averages
Trading with EMAs in the EUR/CHF chart

Moreover, just like in SMA, if prices cross above the EMA from below and the EMA is trending upward, it's considered a buy signal. Conversely, if prices cross below the EMA from above, and the EMA is trending downward, it's considered a sell signal. Meanwhile, the slope of the EMA is important. If the EMA is trending upward and its slope is positive, it indicates an uptrend and provides buying opportunities. If the EMA is trending downward, and its slope is negative, it indicates a downtrend and offers selling opportunities. EMA, by giving more weight to recent data, allows for faster tracking of market movements and quick identification of trend changes. However, this can also increase the risk of generating false signals. Therefore, it's important to use EMA carefully.

Weighted Moving Average (WMA)

This is a type of average calculated by assigning different weights to each data point. It is used to give different levels of importance to data points within a specific period. In other words, WMA is an alternative to other moving average types like Simple Moving Average (SMA) and Exponential Moving Average (EMA). WMA is calculated by assigning different weights to each data point, and these weights determine which data points within the period should be given more importance.

Calculation. WMA calculation formula is as follows:

     WMA(t) = (P1 x W1 + P2 x W2 + ... + Pn x Wn) / (W1 + W2 + ... + Wn)

Here: WMA(t) represents the Weighted Moving Average at time 't.' P1, P2, ..., Pn represent each data point (e.g., closing prices) within a specific period. W1, W2, ..., Wn represent the weights assigned to each data point.

How to Trade. Trading with WMA in financial markets is similar to SMA. That is, if the short-term WMA crosses above the long-term WMA from below, it's interpreted as a buy signal. Rather, if the short-term WMA crosses below the long-term WMA from above, it's seen as a sell signal. The slope of WMA is used to determine the direction of the trend. If WMA is trending upward, and its slope is positive, it indicates an uptrend and is considered a buy signal. Conversely, if WMA is trending downward, and its slope is negative, it indicates a downtrend and is accepted as a sell signal. Additionally, if prices cross above the WMA from below, and the WMA is trending upward, it's a buy signal. Inversely, if prices cross below the WMA from above, and the WMA is trending downward, it's a sell signal. Refer to the example in the GBP/CHF chart below:

Forex trading with short and long-term Weighted Moving Average crossovers
Trading with WMAs in the GBP/CHF chart

WMA is a type of moving average that allows for different weights to be assigned to data points over different periods. This enables users to customize WMA to meet their analysis requirements and market conditions. For instance, those who believe that recent price movements are more critical can assign more weight to recent closing prices, resulting in a more responsive WMA. On the other hand, those who want to give more importance to older data can create a WMA with a longer-term perspective by assigning more weight to older data.

Don't forget. To be successful in financial markets like Forex, it's important to understand the limitations of indicators and strategies and be willing to accept risks. When trading, we should not forget that no single indicator or strategy will always provide correct results. Markets are constantly changing, and every trade carries risks. As a result, we need to have a good plan and execute our strategy in a disciplined way before trading. Also, before investing, we should have knowledge of both technical and fundamental analysis and gain experience through multiple practice sessions. Wishing you profitable trades!

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