Foreign exchange traders use a variety of tools to predict trends in currencies to make profits. In addition to charts, moving averages are among the top indicators used in technical analysis.
When setting up such an average, the trader needs to first specify the time period in a chart. It can be a daily chart (typical for long-term traders), an hourly chart (more suitable for intermediate-term traders), and 5-minute chart (used by short-term traders).
SMA Vs. EMA
Then, a number of periods need to be chosen for an average. An example is a 5-day moving average. A simple moving average (SMA) then takes prices from the last five bars on the chart and averages them. Let’s say the prices of EUR/USD pair were 1, 1.05, 1.1, 1.15, and 1.2. The SMA would be 1.1.
Now, let’s say, the next price would be 1.3. In that situation, the first price (1) would be dropped and the last added. So, the moving average would now use 1.05, 1.1, 1.15, 1.2, and the latest 1.3. After averaging, the level would rise from 1.1 to 1.6.
The other widely used average is the exponential moving average (EMA). Here more weight is given to the latest prices, so with rising trend, EMA would move up faster than SMA.
What’s important to know is that forex traders will see either of these averages behave in different ways since the number of periods used differs among them. The more periods, the smoother the average, meaning it will lag behind changes in prices. On the other hand, a moving overage with just a few periods will change faster.
The averages with more periods tend to be more stable, and are likely to give fewer misleading signals. On the contrary, averages with fewer periods are less stable and give more false signals.
How Many Periods Should Be Used In Forex Trading?
The answer to this question differs among the traders. What’s more, most traders use more than one average on their charts. For long-term bets, 50-day and 200-day averages are often used. In this case, the traders find a decent likelihood of bullish move if the shorter average (50-day) crosses over the longer average (200-day).
On the opposite side, if the short-term moving average falls below its long-term counterpart, then there may be a bearish trend developing. (However, the traders will also look at other indicators, such as chart formations, to confirm.)
For shorter periods, averages including periods for 10, 20, and 50 days can be used. For day traders, the periods used can be on a 5-minute chart, so a 10-period moving average will represent 50 minutes of trading.
Some charts provided by the forex brokers automatically have set-up periods. Averages with 13 and 26 periods are not that uncommon. The suggestion here is to use these default periods and then test to see if they work.
Trading Forex With Triple Moving Averages
Averages using three periods are also common. So, on a single chart (whether it’s daily or even a one-minute chart), three averages will be displayed, and these can be either simple or exponential. Once again, different traders will use varied periods. Some of the more common ones are 4, 9, and 18.
The question here is: How are these three averages used in trading? Usually, when the traders see the 4-period moving average crossing above the 9-period average, it gives an indication that a bullish trend may be developing.
Then, if these two averages start crossing above the 18-period average, a stronger indication is given. Of course, experienced forex traders will also look at other factors for confirmation such as chart formations or oscillators (i.e. RSI).
Technical analysis systems have other indicators based on averages. Moving Average Convergence Divergence MACD) is among the most popular ones. It shows a relationship between two exponential moving averages (such as 26 and 12 periods). Together with these two periods, another period (such as 9) is used as a signal.
Many forex technical analysis systems will use graphs to display the 26 and the 12 periods, while the 9 period will be a trigger line. (If it changes from falling to rising, it may mean a trend is changing.)
For a rising trend, green bars will be displayed above the line (and their steepness will indicate their strength), while for a falling trend, red bars will be displayed below the line.
At times, MACD is used as a divergence indicator. For example, if the price reaches a peak, but MACD shows downturn, it is possible that an uptrend is reversing.
It is important to note, though, that at times MACDs do give false, or premature, signals. So these should be used with caution and combined with other indicators for confirmation.