Trading Elementary School Lesson 4 – Full Lesson List:
This is the average closing price of a trading pair, over the last ‘x’ number of periods. It smoothes out the price action, as can be seen below:
The slope of the moving average will help us decide the direction of market prices. It is another indicator; another tool in our trading arsenal.
As we said, moving averages smooth out price actions.
There are different types of moving averages. Here we will address the 2 main types:
Here we’ll teach you what they are and how to use them.
1. Simple Moving Averages (SMA)
This is the closing price for the last ‘x’ periods, divided by x. It’s a simple, basic, averaging formula. Hence the name.
By example, to plot a 5-period SMA on a 30 minute chart, take the close prices of the last 150 mins., then divide that number by 5.
Good charting software will do this for you. Again, if you need any recommendations, contact our support desk.
There are 3 different SMAs on this chart.
The 62 SMA is further from the current price than the 30 SMA. The 30 SMA is further than the 5 SMA, and so on. This is because, for example, the 62 SMA divides the addition of the closing prices for the last 62 periods, by 62.
SMAs indicate market sentiment and are good for spotting trends. Here there is an obvious bull trend. SMAs, as you can see, give us a good broader view.
2. Exponential Moving Averages (EMAs)
Spikes can distort the SMA. That’s why we have the Exponential Moving Average (EMA). The best is to illustrate this by way of an example.
Closing prices for last 5 days are: 1.3172 (Day 1), 1.3231 (Day 2), 1.3164 (Day 3), 1.3186 (Day 4), 1.3293 (Day 5). Therefore SME = Sum of Day 1-5 / 5 = 1.3209
However, an outlier event, such as a bad news report on day 2 could cause the SME to be much lower, due to a day 2 price plunge. This is misleading because day 2 is just a one time event. It would skew the data and misleading your trading information.
So, for that reason, we have the EMA. This would give more weight to the most recent days (3, 4, and 5). It emphasises traders most recent activity. And, for this reason, can often be more accurate.
The 30 EMA is closer to the price than the 30 SMA, on our chart below. It is a more accurate representation of price action.
Remember, in trading, it is far more important what traders are doing now. That is why the EMA is usually more accurate.
Both have their upsides and their downsides in trend analysis (excuse the pun).
A short period EMA can help you catch trends very early. If you catch a trend earlier you can ride it for profit longer.
However, EMA responds to the price quickly. So it can be deceptive. It may lead you to believe a trend is forming. In actuality this may just be a price spike. In such a case a SMA would have been more useful. Because it is smoother, responding slower, a longer period SMA would not have faked you out.
A longer period SMA is helpful for spotting the longer-term trend, over longer time frames.
However, for the SMA, the negative is that it may be too slow and you may miss a good entry point altogether.
Basically, the SMA is slow. And the EMA is fast.
So, in terms of the trade-off, with the SMA you might miss out on riding the trend early enough. This could cost your profit. But, you would also avoid getting caught up in a fakeout price move.
The EMA, being fast, lets you spot a trend early and maximize profit. But you are at risk of price fake-outs.
Good traders will use a combination of both. For example, a longer period SMA could show the overall trend. While a shorter period EMA would indicate the best time to enter a trade position.
We’re going to get into some specific trading strategies involving these tools right now.
Moving averages can be used to find trends. We did say that earlier.
The easiest way to do this is to plot SMA. If the price action trends above the SMA, it is a good indicator we are in a sustained uptrend.
If it stays below the SMA, we have a sustained downtrend.
This does, of course, leave you very prone to fake-outs on outlier events. That can seriously damage your trading balance.
That change in trend on the above chart could very well just be a reaction to some short term news. You act on it and you lose out because it is not sustained.
By plotting a couple of MAs you get a clearer picture of the trend.
To elaborate, an uptrend should have the ‘faster’ MA above the ‘slower’ MA. On the below chart the 10 SMA (faster) is above the 20 SMA (slower). This is indicative of a true uptrend. Here you have used to SMAs to help assess the true market situation.
We see a nice uptrend from April – July. The top was about 124. From there it slowly headed downwards. At around the middle of July the 10 SMA crossed below the 20 SMA. If you took a short position where the moving averages crossed you would have made a lot of money.
So where SMAs cross-over like this is a good time to take the appropriate position.
Please note that this crossover system is best suited to volatile and trending environments. When the price is ranging it does not work so well.
Many traders will use the MA as dynamic support / resistance levels. They are dynamic because, unlike traditional support / resistance indicators, they are constantly changing according to the recent price action.
This strategy involves buying when the price drops and tests the MA. Or, alternatively, selling when the price rises and touches the MA.
From the above we can see that every time the price touched the 50 EMA it found resistance.
The price won’t always bounce off the EMA perfectly, it may shoot a little past it, just like your tradition support/resistance lines.
A slightly alternative strategy that is safer, is to setup 2 MAs and buy/sell only when the price is in the middle of the space between the 2, otherwise known as ‘the zone’, as below.
Register for a trading account here.