There are a lot of indicators in the trading market but a Moving Average seems to be of the most popular.
The majority of technical traders, even fundamentalists use this indicator for trading and analysis because of its simplicity. For applying it on the chart just drag it into pieces. It works the same as most indicators, you should buy when the indicator is above the moving average line and sell when it is below.
There are different types of moving averages, for example, Volume Adjusted and Variable, Simple Moving Average, Linear Weighted and others.
If you are beginner you may hesitate which method you should use.
Simple Moving Average (Arithmetic)
A lot of newcomers start their currency trading with the Simple Average (Arithmetic).
To calculate this you need to add the closing price of the candlesticks number, which is the same with the moving average time period. The next step is to divide this number by the total number of pieces. The final result will be called as the average. The third step is to discard the oldest price from the calculation and to apply the same formula to the following pieces. After finishing all the process you will have the moving average.
Let’s look at the example. We will calculate a 5-period moving average, the prices of which are from index 7 to 3. Then we drop the 7 index price and the next average will include prices of 6 to 2 index. Then the 6 index price is discarded and we will calculate the prices from 5 to 1 index:
Here you can see the formula:
Simple Moving Average = [Price(n) + Price(n-1) + Price(n-2) + … + Price(1)] / n
Where n is the period of the moving average.
But there are some disadvantages of the simple moving average which experienced traders understand better than the beginners. Lagging is the first one because it concentrates only on those prices in the period of time and assigns equal weight to all prices in the time interval. Technical analysts created other methods to get rid of the cons. Let’s examine what they are.
EMA is a method which takes into account all prices and it is an advantage because the previous method calculates only the prices in the predefined period. Such approach helps to get rid of equal weight issues. However, the problem with lagging remains a disadvantage.
Here is the EMA formula:
EMA = (Price(i)*P)+(EMA(i-1)*(1-P))
Where P is the period and i is the candlestick index.
This formula can be better understood by experienced traders, newcomers can cave some troubles. That is why we will try to show it in a simpler way in order to explain it to everybody:
EMA = (Price current – EMA previous) * multiplier + EMA previous
Where multiplier = 2/Periods + 1
Now we will concentrate on a 10-period Exponential Moving Average calculation. Pay attention to the fact that the oldest EMA (in our case it is 10) is calculated as in the previous method.
Multiplier = 2/(Period+1)
Quantity of Periods
The biggest problem for every trader is to decide how many periods they need for using with the EMA.
When you are about to make a decision look at few variables which are very important:
• Market Convention
• The predominant cycle
In the stock exchange there is a tendency of using 200-periods long moving averages, traders usually choose such number. However, if we take forx trading there will be a shorter period. It can be 10, 20 or 50. Volatility is another important factor, which depends on the market type. While low volatility tries to avoid false signals and uses longer lengths, trending markets have a tendency of implying shorter periods. To recognize the best possible period use a frequent optimization. But there are traders who use constant period no matter what type of market do they have.
Analyzing of Trends
To make everything easier use a moving average with the trend identification. An upward moving can be seen when prices bounce above the line.
When prices are below the line it means there is a downward movement, it is obvious.
It is very easy to identify a trend with moving averages because the principle is simple: when prices are far from the moving average the market is overbought. On the other hand, when the prices move down from the moving average it is a signal that the trading is oversold.
How to Define
There are two variants of signals: buy and sell. The principle is the same with the Simple Moving Average: a buy signal can be seen when the prices are above the moving average and, vice versa, when they are moving down there is a sell signal. Remember to prove all the signals in order to prevent you from false signals. A buy signal and a sell one require different closes. A buy signal needs a close above the moving average and a sell – below.
Unfortunately, false signals are still a big problem of moving averages. To get rid of them you need to confirm every signal with the price. There is one more solution – to be patient and to wait until the “tip” of the moving average line will turn upwards, only after that, you can place any buy order.
The combination of moving averages and indicators provides the trader with good profits. It is similar to oscillators too.
To Sum Up
A lot of traders like to use The Exponential Moving Average because of its advantages. It is so common because in some ways it is better than the simple moving average. Recognizing the trend is simpler with the EMA. But the disadvantage is that signals can be a delay at the same time with false signals occur, then there is a risk when caught in a sideways market.