Moving Averages

Many technical traders use a relatively simple analytic technique involving moving averages to generate trading signals and follow trends. Moving averages consist of an average of observed exchange rates taken over a set time period that then itself progresses or moves through time.

While traders often simply compute moving averages based on closing prices, other more complicated methods exist that can take the daily ranges into account. The end result of this calculation plotted over time forms a smooth line that tends to lag behind the actual exchange rate levels observed in the market.

Types of Moving Averages

While the first type has the distinct advantage of simplicity, it can tend to lag the price action since it gives more recent rates the same weight as rates seen at the beginning of the time period. The latter two methods correct for this issue by placing greater emphasis on more recent price action. As a result, the exponential and weighted moving averages show a reduced lag by being more responsive to recent prices.

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Computing Moving Averages

When learning how to computing moving averages, most traders will start with the calculation for the simple moving average. Its equation looks like this:

Where N represents the number of time periods for which prices are included in computing the average.

The equations for the exponential and weighted moving averages are more complex.
Nevertheless, more weight will generally be given to more recent price data to reduce the aforementioned lag relative to current exchange rate levels and thereby increase the relevance of the average and the timeliness of its trading signals.

Trading Using Moving Averages

The signal for such a trader to take a long position comes when the level of the exchange rate or shorter-term moving average crosses upward above the other moving average used in the analysis. Conversely, a short signal gets generated when a downward cross-over arises.

When organizing price charts using moving averages, it generally makes sense to place them in different colors so that you can easily distinguish the shorter-term moving average from the longer-term average at a glance.

The Moving Average Convergence Divergence Indicator

A popular technical indicator based on crossovers between moving averages is known as the Moving Average Convergence Divergence (MACD) histogram and indicator. While many relatively complex forex trading plans involve this indicator, in its simplest usage, when the histogram passes from negative to positive, a buy signal gets generated, and when it falls from positive to negative, a sell signal ensues.

While 12 and 26 day exponential averages are commonly used with this indicator, the MACD can be parameterized in a variety of ways, including whether to use either simple, exponential or weighted averages.