The following is a guest post by forextraders.com.
The “Simple Moving Average”, or “SMA”, is perhaps our oldest and one of the most popular technical indicators used by investors across all forms of investment vehicles, including the world of forex trading. Unlike most other indicators, we cannot attribute its origination to any one person or time period, but as soon as the first person applied simple mathematics to analyzing pricing behavior, the SMA was born. The SMA is flexible and is often used in concert with other indicators or with itself by varying the period settings that are used in its calculations.
The variables involved with computing an SMA are twofold – the price and the number of periods to include. A trader can vary the price variable by using either the open, close, high, or low for each period, but the general rule is to use the closing price value. The period setting applies to the particular timeframe of your chart, whether you have chosen a 5-minute or even a daily chart presentation. If the period setting is “20”, then the calculation will take the closing price for each of the past twenty periods, add them up, and then divide by “20”. The result is the SMA at one point in time.
Traders will often use as many as three SMA’s at one time to gauge how quickly price behavior is modifying itself over a specific timeframe. The more popular combinations for currency trading are “4,9,18”, “5,20,60”, and “7,21,90”, as opposed to stocks where trends occur over longer periods of time and the preferred combination may be “20,50,100”. The diagram below illustrates how the former combination would appear for an hourly depiction of the “EUR USD” currency pair:
The “Red”, “Blue” and “Green” lines denote the respective “4,9,18” settings. Obviously, the smaller the setting, the more quickly the average follows actual pricing behavior. The SMA is also referred to as a “lagging” indicator because it reflects previous changes in price, but does not make any prediction as to any imminent changes down the line, as with popular oscillating indicators. The combination above, however, can generate valid trading signals based on line intersections alone or when the candlestick formations cross over a specific moving average.
An SMA is often used to confirm a trend suggested by an oscillator like the “Relative Strength Index”, or “RSI” for short. The RSI is known as a “leading” indicator because of its ability to forecast an imminent change in pricing behavior. The weakness of an oscillator is its inability to predict when the change will occur. An SMA can provide the additional insight that a new trend is forming by simply changing its direction.
Analysts have also enhanced moving averages by varying the calculation method. An “EMA” or, exponential moving average, gives a heavier weighting to more recent price-points with the intent of reacting more quickly to changes in the market. One may also encounter a “Smoothed” or “Linear Weighted” variety of the moving average on popular forex trading platforms, each providing another nuance to the signal of the moving average. One common use of a “Smoothed” moving average is to add it to the RSI indicator portion of the chart. This MA will compute values based on the RSI alone, another way to improve this “leading” indicator.
Traders use an SMA due to its visual simplicity. Trends can be easily detected for the currency pair at hand or for the technical indicator that needs confirmation of its trading signals. Caution is required when volatility is present, and adjusting period settings can provide additional clues for trading.
This was a guest post by forextraders.com.
[Mich] I am not an adept of technical analysis so I would love to hear the opinion of those amongst you who are. Do you use moving averages amongst other indicators? How much “faith” do you put in its movement for your buy/ sell operations?