The core practice to profit from the forex market is to speculate the market trend, ride with it, and hope it goes in your position’s direction.
One of the best ways to identify potential market trends is through moving averages (MA). In the forex market, MA is among the most popular methods to analyze the market trend and strategize trades.
When looking at the price chart, beginner traders will likely be overwhelmed by the graphs, numbers, and market directions shown in the diagram. But with the Moving Averages, you can smooth out the data presented and easily see the price fluctuations.
Using the MA is helpful to clear out the market noise and see the trend direction. Traders using MA must calculate the market’s average movement for a specific period. After this, the trader will plot the MA to the chart, allowing them to analyze and identify market trends.
But how do you identify the MA in your price chart? Simply look at the squiggly line that stays atop the market price. That’s it. That’s your asset’s MA.
An upward MA signifies a potential upward price movement of the market. Likewise, the downward movement suggests a possible decline in the market value.
Remember: Moving Averages don’t predict the price direction; they suggest the market trend.
Let’s look at Finn’s trading situation to better understand how MA works in your trading position.
Finn wants to trade the EUR/USD but doesn’t know which position to open. He uses his price chart, sets it at a 24-hour frame, and sets a 3-day MA.
When he set up his price chart, he noticed a squiggly line overlaying the top of the market price. He knows that it’s the main market trend.
Upon watching the market price and the MA line, he found that the EUR/USD price level was above the MA. Based on analyzing MA and other indicators, the wisest decision is to enter a buy (go long) position because his analysis suggests that the market has the potential to appreciate.
Moving Averages (MA) are best used when you know what kind of data and how much data you’re aiming to have. Essentially, you should use these two MAs based on your trading strategy and the market condition you’re in.
The Simple Moving Average (SMA) is the simplest MA. As the term implies, a simple moving average is a straightforward technical indicator.
Here, you basically just add up the last period’s closing price and then divide it by the number of X (or the represented number of periods).
It is determined using this formula;
SMA= (A1 + A2 + ... An) / n
Whereas;
A refers to the average period in n
n represents the number of periods.
Assume you want to analyze the 3-day SMA of the EUR/USD currency pair. You should find the closing prices for each trading day, add the values together, and divide them by 3.
SMA= (A1 + A2 + A3) / 3
SMA= (1.2000 + 1.1980 + 1.2015) / 3
SMA= 1.1998
Unlike the SMA, the Exponential Moving Average (EMA) focuses more on recent market prices. This is to make more relevant and responsive decisions regarding new information.
To calculate the EMA, you need to;
Let’s return to the previous example and use its SMA value (1.1998). So, the available values are;
| SMA= 1.1998 | EMA Multiplier= ? | Current EMA= ? |
To calculate the EMA multiplier, you’ll use the number of periods on the last SMA (3 days)
EMA Multiplier= [2/ (3 + 1)]
EMA Multiplier= [2/ 4]
EMA Multiplier= 0.5
So now, here’s what your EMA calculation should look like:
| SMA= 1.1998 | EMA Multiplier= 0.5 | Current EMA= ? |
To calculate the EMA, you need to look at your price chart, find the closing price and the previous EMA, and use it together with others given to find the current EMA.
Let’s assume that the closing price is 1.2000 and the previous EMA is 1.1980;
Current EMA= [1.2000 - 1.1980] x 0.5 + 1.1980
Current EMA= 0.0020 x 0.5 + 1.1980
Current EMA= 0.0010 + 1.1980
Current EMA= 1.1990
| SMA= 1.1998 | EMA Multiplier= 0.5 | Current EMA= 1.1990 |
Lots of numbers, no? Well, you don’t need to calculate these by yourself. Upon setting up the MA indicators to your price chart, you’ll automatically see the MA line overlaying the chart.
But remember, knowing how to would help you to tweak and improve your trading system.