Lesson 1: Moving Averages

Types of Moving Averages

Overview

  • There are several types of moving averages available to meet differing market analysis needs. The most commonly used by traders include the following:
    1. Simple Moving Average

    2. Weighted Moving Average

    3. Exponential Moving Average

Simple Moving Average (SMA)

  • A simple moving average is the most basic type of moving average. It is calculated by taking a series of prices (or reporting periods), adding these prices together and then dividing the total by the number of data points.
  • This formula determines the average of the prices and is calculated in a manner to adjust (or "move") in response to the most recent data used to calculate the average.
  • For example, if you include only the most recent 15 exchange rates in the average calculation, the oldest rate is automatically dropped each time a new price becomes available.
  • In effect, the average "moves" as each new price is included in the calculation and ensures that the average is based only on the last 15 prices.

With a little trial and error, you can determine a moving average that fits your trading strategy. A good starting point is a simple moving average based on the last 20 prices.

Weighted Moving Average (WMA)

  • A weighted moving average is calculated in the same manner as a simple moving average, but uses values that are linearly weighted to ensure that the most recent rates have a greater impact on the average.
  • This means that the oldest rate included in the calculation receives a weighting of 1; the next oldest value receives a weighting of 2; and the next oldest value receives a weighting of 3, all the way up to the most recent rate.
  • Some traders find this method more relevant for trend determination especially in a fast-moving market.

The downside to using a weighted moving average is that the resulting average line may be "choppier" than a simple moving average. This could make it more difficult to discern a market trend from a fluctuation. For this reason, some traders prefer to place both a simple moving average and a weighted moving average on the same price chart.



Candlestick Price Chart with Simple Moving Average and Weighted Moving Average
Candlestick Price Chart with Simple Moving Average and Weighted Moving Average

Exponential Moving Average (EMA)

  • An exponential moving average is similar to a simple moving average, but whereas a simple moving average removes the oldest prices as new prices become available, an exponential moving average calculates the average of all historical ranges, starting at the point you specify.
  • For instance, when you add a new exponential moving average overlay to a price chart, you assign the number of reporting periods to include in the calculation. Let's assume you specify for the last 10 prices to be included.
  • This first calculation will be exactly the same as a simple moving average also based on 10 reporting periods, but when the next price becomes available, the new calculation will retain the original 10 prices, plus the new price, to arrive at the average.
  • This means there are now 11 reporting periods in the exponential moving average calculation while the simple moving average will always be based on just the most recent 10 rates.

Deciding on Which Moving Average to Use

  • To determine which moving average is best for you, you must first understand your needs.
  • If your main objective is to reduce the noise of consistently fluctuating prices in order to determine an overall market direction, then a simple moving average of the last 20 or so rates may provide the level of detail you require.
  • If you want your moving average to place more emphasis on the latest rates, a weighted average is more appropriate.
  • Keep in mind however, that because weighted moving averages are affected more by the latest prices, the shape of the average line could be distorted potentially resulting in the generation of false signals.
  • When working with weighted moving averages, you must be prepared for a greater degree of volatility.


Simple Moving Average Weighted Moving Average
PROS
Reduces the noise associated with fluctuating rates making it easier to identify trends and trend reversal points. More appropriate for a fast-moving, ranging market and makes it easier to see the effect of more recent rates.
CONS
Slow to react to latest rates so buy and sell signals lag even further behind the market. More likely to send a false trade signal.


Moving averages – whether simple, weighted, or exponential – are all lagging indicators. This means that they are based on events that have already occurred in the market as opposed to predictive indicators used to form an opinion on future market direction.

While it is true that moving averages lag behind the spot rate, their real contribution is helping to determine the strength of the current market trend and to distinguish true market reversal points from typical exchange rate fluctuations.

This is for general information purposes only - Examples shown are for illustrative purposes and may not reflect current prices from OANDA. It is not investment advice or an inducement to trade. Past history is not an indication of future performance.

Trading FX and/or CFDs on margin is high risk and not suitable for everyone. Losses can exceed investment.