MOVING AVERAGES

Moving averages are one of the oldest and most commonly used technical indicators. They "smooth out" fluctuations to help you distinguish between typical market fluctuations and actual rate reversals.

UNDERSTANDING MOVING AVERAGES

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 moving averages do 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.

Moving Average help you distinguish between typical market fluctuations and actual rate reversals

CHOOSING THE NUMBER OF REPORTING PERIODS

The number of reporting periods included in the moving average calculation affects the moving average line as displayed in a price chart. 

  • The fewer the data points (i.e. reporting periods) included in the average, the closer the moving average stays to the spot rate, thereby reducing its value and offering little more insight into the overall trend than the price chart itself.
  • On the other hand, the greater the number of data points included in the moving average calculation, the less any single rate can affect the overall average. A moving average that includes too many points evens out the price fluctuations to such a degree that a discernible rate trend cannot be detected.

Either situation can make it difficult to recognize reversal points with sufficient time to take advantage of a rate trend reversal. For this reason, it is important to select the number of data points that provides the level of price detail appropriate for the length of time you hold the trade open and your overall trading style. In this EUR/USD daily chart example, the fast 7-day SMA follows closely to the candlesticks, where the 180-day SMA shows a slow, steady, upward trend.

Buy signal spot rate crosses over the moving average

3-TYPES OF MOVING AVERAGES

INTERPRETING MOVING AVERAGE SIGNALS

When using spot rate and moving average cross over trading signals, it is important to keep two points in mind:

MARKET VOLATILITY

Depending on market volatility, cross overs can be extremely unreliable so it is advisable to seek additional confirmation before acting. In the buy and sell examples below we examined here, the formation of a double-top and a reverse head-and-shoulders pattern helped confirm the market direction.

REPORTING PERIODS

The number of reporting periods included in the moving average calculation can have a tremendous effect on the moving average. The basic rule to remember is that the fewer the number of reporting periods, the closer the average stays with the spot rate.

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Using Moving Averages (MAs)

For traders dealing in a volatile, fast-moving market, the potential for false signals is a constant concern. The greater the degree of price volatility, the greater is the chance that a false signal is generated. Moving averages are essential to other types of technical analysis as well - most notably Bollinger Bands® and Stochastic measurements.

BUY SIGNALS

When the spot rate crosses over the moving average, it may indicate that the spot rate is trending upwards as it is increasing at a faster rate than the moving average. This is typically seen as a potential buy opportunity.

Again, it is wise to confirm the analysis. In this example, the reverse head and shoulders pattern is a common rate reversal signal.

Single Moving Average and Spot Rate Buy Signal

SELL SIGNALS

When the spot rate crosses under the moving average it suggests that the market price is losing momentum and is under-performing when compared to the moving average, indicating a sell signal.

The fact that the double-top chart pattern occurs at roughly the same point in this example reinforces the level as a likely sell opportunity.

Under-performing when compared to the moving average indicating a sell signal

MULTIPLE CROSSOVERS

Traders can place several moving averages on the same price chart. Typically, the faster moving average consisting of fewer data points will be selected, as well as a slower moving average. In this chart for example, the slower SMA is set at 30 days, and the faster SMA at 7 days.

When the fast moving average crosses above the slower moving average is considered a buy signal. Conversely, when the faster moving average crosses below the slower moving average, it is considered a sell signal.

In this chart we included only two moving averages to keep clutter to a minimum, but in practice you can have as many moving averages of varying speed as you like. Some traders like to add a very-slow moving average, like 200, as this removes almost all fluctuations and shows a longer-term market direction.

Multiple crossovers can place several moving averages on the same price chart

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Execution speed numbers are based on the median round trip latency measurements from receipt to response for all Market Order Fills executed between June 1st and Sept 1st 2016 on the OANDA legacy and OANDA v20 execution platforms, excepting MT4 initiated orders.

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