How Moving Averages Work
This section covers the basic technical indicators used in forex trading, the most common of which is the moving average.
As the name suggests, this kind of technical indicator measures the average closing price of the currency pair for a specified period. For example, using the moving average (20) on an hourly chart takes the average of the closing price for the past 20 hours.
There are two main types of moving averages: simple and exponential. This has to do with the method in which the average is generated, with the simple moving average taking the sum of the closing prices then dividing by the number of time periods and the exponential moving average assigning weights to more recent time periods.
Either way, the goal in using moving averages in technical analysis is to smooth out price action and get a better idea of how future price movement will fare. Simple moving averages allow you to see a general idea of past price action while exponential moving averages incorporate the latest price volatility.
Moving averages can be used as a single indicator or as a group. As a single indicator, this is often used to generate buy or sell signals based on price crossovers. It can also be treated as a dynamic support or resistance level in a market trend.
Using multiple moving averages is also useful for crossover systems. For instance, a trading system can specify that buy signals would be generated when the moving averages are arranged from shortest-term to longest-term. A sell signal could be generated when the moving averages are arranged from longest-term to shortest-term from top to bottom.
Which kind of moving average should you use? This depends on the type of trading strategy you are planning on using. In particular, traders who are more aggressive with their entry orders and are inclined to enter trends as soon as they start may prefer a short-term exponential moving average since this is very sensitive to recent price action. The downside to this method though is that it can be prone to fake outs.
As for exits, moving averages can also give signals to close a trade when a new crossover has taken place. This is usually seen as a sign that a reversal is forming and that it may be time to book profits
Next Article: Types of Technical Indicators