Moving averages

What Are Moving Averages?

A moving average is simply a way to smooth out price action over time. By “moving average”, we mean that you are taking the average closing price of a currency pair for the last ‘X’ number of periods. On a chart, it would look like this:

Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.

As we said, moving averages smooth out price action.

There are different types of moving averages and each of them has their own level of “smoothness”.

Generally, the smoother the moving average, the slower it is to react to the price movement.

The choppier the moving average, the quicker it is to react to the price movement. To make a moving average smoother, you should get the average closing prices over a longer time period.

Now, you’re probably thinking, “C’mon, let’s get to the good stuff. How can I use this to trade?”

In this section, we first need to explain to you the two major types of moving averages:

  1. Simple
  2. Exponential

We’ll also teach you how to calculate them and give the pros and cons of each. Just like in every other lesson in the BabyPips.com School of Pipsology, you need to know the basics first!

After you’ve got that on lockdown like Argentinian soccer player Lionel Messi’s ball-handling skills, we’ll teach you the different ways to use moving averages and how to incorporate them into your trading strategy.

By the end of this lesson, you’ll be just as smooth as Messi’s!

Are you ready?

If you are, give us a “Heck yeah!”

If not, go back and reread the intro.

Once you’re pumped and ready to go, head to the next page.

Simple Moving Average (SMA) Explained

A simple moving average (SMA) is the simplest type of moving average in forex analysis (DUH!). Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X.

Confused???

Don’t worry, we’ll make it crystal clear.

Calculating the Simple Moving Average (SMA)

If you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5. Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average!

If you were to plot a 5-period simple moving average on a 10-minute currency chart, you would add up the closing prices of the last 50 minutes and then divide that number by 5.

If you were to plot a 5 period simple moving average on a 30 minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.

If you were to plot the 5 period simple moving average on the 4 hr. chart… Okay, okay, we know, we know. You get the picture!

Most charting packages will do all the calculations for you. The reason we just bored you (yawn!) with a “how to” on calculating simple moving averages is because it’s important to understand so that you know how to edit and tweak the indicator.

Understanding how an indicator works means you can adjust and create different strategies as the market environment changes.

Now, as with almost any other forex indicator out there, moving averages operate with a delay. Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of “future” short term price action.

Here is an example of how moving averages smooth out the price action.

On chart above, we’ve plotted three different SMAs on the 1-hour chart of USD/CHF. As you can see, the longer the SMA period is, the more it lags behind the price.

Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMAs.

This is because the 62 SMA adds up the closing prices of the last 62 periods and divides it by 62. The longer period you use for the SMA, the slower it is to react to the price movement.

The SMAs in this chart show you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.

Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now gauge the general direction of its future price. With the use of SMAs, we can tell whether a pair is trending up, trending down, or just ranging.

There is one problem with the simple moving average: they are susceptible to spikes. When this happens, this can give us false signals. We might think that a new currency trend may be developing but in reality, nothing changed.

In the next lesson, we will show you what we mean, and also introduce you to another type of moving average to avoid this problem.

Exponential Moving Average (EMA) Explained

As we said in the previous lesson, simple moving averages can be distorted by spikes. We’ll start with an example.

Let’s say we plot a 5-period SMA on the daily chart of EUR/USD.

The closing prices for the last 5 days are as follows:

Day 1: 1.3172

Day 2: 1.3231

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

The simple moving average would be calculated as follows:

(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209

Simple enough, right?

Well what if there was a news report on Day 2 that causes the euro to drop across the board. This causes EUR/USD to plunge and close at 1.3000. Let’s see what effect this would have on the 5 period SMA.

Day 1: 1.3172

Day 2: 1.3000

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

The simple moving average would be calculated as follows:

(1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163

The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 was just a one-time event caused by the poor results of an economic report.

The point we’re trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmm… Wait a minute… Yep, there is a way!

It’s called the Exponential Moving Average!

Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.

This would mean that the spike on Day 2 would be of lesser value and wouldn’t have as big an effect on the moving average as it would if we had calculated for a simple moving average.

If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders are doing recently.

Exponential Moving Average (EMA) and Simple Moving Average (SMA) Side By Side

Let’s take a look at the 4-hour chart of USD/JPY to highlight how a simple moving average (SMA) and exponential moving average (EMA) would look side by side on a chart.


 

Notice how the red line (the 30 EMA) seems to be closer price than the blue line (the 30 SMA). This means that it more accurately represents recent price action. You can probably guess why this happens.

It’s because the exponential moving average places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing NOW rather what they were doing last week or last month.

Simple vs. Exponential Moving Averages

By now, you’re probably asking yourself, which is better? The simple or the exponential moving average?

First, let’s start with the exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go.

These can help you catch trends very early (more on this later), which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits (boo yeah!).

The downside to using the exponential moving average is that you might get faked out during consolidation periods (oh no!).

Because the moving average responds so quickly to the price, you might think a trend is forming when it could just be a price spike. This would be a case of the indicator being too fast for your own good.

With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.

This would work well when looking at longer time frames, as it could give you an idea of the overall trend.

Although it is slow to respond to the price action, it could possibly save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good entry price or the trade altogether.

An easy analogy to remember the difference between the two is to think of a hare and a toirtoise.

The tortoise is slow, like the SMA, so you might miss out on getting in on the trend early. However, it has a hard shell to protect itself, and similarly, using SMAs would help you avoid getting caught up in fakeouts.

On the other hand, the hare is quick, like the EMA. It helps you catch the beginning of the trend but you run the risk of getting sidetracked by fakeouts (or naps if you’re a sleepy trader).

Below is a table to help you remember the pros and cons of each.

  SMA EMA
Pros Displays a smooth chart which eliminates most fakeouts. Quick Moving and is good at showing recent price swings.
Cons Slow moving, which may cause a a lag in buying and selling signals More prone to cause fakeouts and give errant signals.

So which one is better?

It’s really up to you to decide.

Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.

There are a number of trading strategies that are built around the use of moving averages. In the following lessons, we will teach you:

  1. How to use moving averages to determine the trend
  2. How to incorporate the crossover of moving averages into your trading system
  3. How moving averages can be used as dynamic support and resistance

Time for recess! Go find a chart and start playing with some moving averages! Try out different types and try experimenting with different periods. In time, you will find out which moving averages work best for you.

How to Use Moving Averages to Find the Trend

One sweet way to use moving averages is to help you determine the trend.

The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it signals that price is in a general uptrend.

If price action tends to stay below the moving average, then it indicates that it is in a downtrend.

The problem with this is that it’s too simplistic.

Let’s say that USD/JPY has been in a downtrend, but a news report comes out causing it to surge higher.

You see that the price is now above the moving average. You think to yourself:

“Hmmm… It looks like this pair is about to shift direction. Time to buy this sucker!”

So you do just that. You buy a billion units cause you’re confident that USD/JPY is going to go up.

 

Bammm! You get faked out! As it turns out, traders just reacted to the news but the trend continued and price kept heading lower!

What some traders do – and what we suggest you do as well – is that they plot a couple of moving averages on their charts instead of just one. This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.

In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa. For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:

Above is a daily chart of USD/JPY. Throughout the uptrend, the 10 SMA is above the 20 SMA. As you can see, you can use moving averages to help show whether a pair is trending up or down. Combining this with your knowledge on trend lines, this can help you decide whether to go long or short a currency.

You can also try putting more than two moving averages on your chart. Just as long as lines are in order (fastest to slowest in an uptrend, slowest to fastest in a downtrend), then you can tell whether the pair is in an uptrend or in a downtrend.

How to Use Moving Average Crossovers to Enter Trades

By now, you know how to determine the trend by plotting on some moving averages on your charts. You should also know that moving averages can help you determine when a trend is about to end and reverse.

All you have to do is plop on a couple of moving averages on your chart, and wait for a crossover. If the moving averages cross over one another, it could signal that the trend is about to change soon, thereby giving you the chance to get a better entry. By having a better entry, you have the chance to bag mo’ pips!

Let’s take another look at that daily chart of USD/JPY to help explain moving average crossover trading.

From around April to July, the pair was in a nice uptrend. It topped out at around 124.00, before slowly heading down. In the middle of July, we see that the 10 SMA crossed below the 20 SMA.

And what happened next?

A nice downtrend!

If you had shorted at the crossover of the moving averages you would have made yourself almost a thousand pips!

Of course, not every trade will be a thousand-pip winner, a hundred-pip winner, or even a 10-pip winner.

It could be a loser, which means you have to consider things like where to place your stop loss or when to take profits. You just can’t jump in without a plan!

What some traders do is that they close out their position once a new crossover has been made or once price has moved against the position a predetermined amount of pips.

This is what Huck does in her HLHB system. She either exits when a new crossover has been made, but also has a 150-pip stop loss just in case.

The reason for this is you just don’t know when the next crossover will be. You may end up hurting yourself if you wait too long!

One thing to take note of with a crossover system is that while they work beautifully in a volatile and/or trending environment, they don’t work so well when price is ranging.

You will get hit with tons of crossover signals and you could find yourself getting stopped out multiple times before you catch a trend again.

How to Use Moving Averages as Dynamic Support and Resistance Levels

Another way to use moving averages is to use them as dynamic support and resistance levels.

We like to call it dynamic because it’s not like your traditional horizontal support and resistance lines. They are constantly changing depending on recent price action.

There are many forex traders out there who look at these moving averages as key support or resistance. These traders will buy when price dips and tests the moving average or sell if price rises and touches the moving average.

Here’s a look at the 15-minute chart of GBP/USD and pop on the 50 EMA. Let’s see if it serves as dynamic support or resistance.

It looks like it held really well! Every time price approached 50 EMA and tested it, it acted as resistance and price bounced back down. Amazing, huh?

One thing you should keep in mind is that these are just like your normal support and resistance lines.

This means that price won’t always bounce perfectly from the moving average. Sometimes it will go past it a little bit before heading back in the direction of the trend.

There are also times when price will blast past it altogether. What some forex traders do is that they pop on two moving averages, and only buy or sell once price is in the middle of the space between the two moving averages.

You could call this area “the zone.”

Let’s take another look at that 15-minute chart of GBP/USD, but this time let’s use the 10 and 20 EMAs.

From the chart above, you see that price went slightly past the 10 EMA a few pips, but proceeded to drop afterwards.

There are some traders who use intraday strategies just like this. The idea is that just like your horizontal support and resistance areas, these moving averages should be treated like zones or areas of interest.

The area between moving averages could therefore be looked upon as a zone of support or resistance.

Breaking through Dynamic Support and Resistance

Now you know that moving averages can potentially act as support and resistance. Combining a couple of them, you can have yourself a nice little zone. But you should also know that they can break, just like any support and resistance level!

Let’s take another look at the 50 EMA on GBP/USD’s 15-min chart.

In the chart above, we see that the 50 EMA held as a strong resistance level for a while as GBP/USD repeatedly bounced off it.

However, as we’ve highlighted with the red box, price finally broke through and shot up. Price then retraced and tested the 50 EMA again, which proved to be a strong support level.

So there you have it folks!

Moving averages can also act as dynamic support and resistance levels.

One nice thing about using moving averages is that they’re always changing, which means that you can just leave it on your chart and don’t have to keep looking back in time to spot potential support and resistance levels.

You know that the line most likely represent a moving area of interest. The only problem of course is figuring out which moving average to use!

How to Use Bollinger Bands

Congratulations on making it to the 5th grade! Each time you make it to the next grade you continue to add more and more tools to your trader’s toolbox.

“What’s a trader’s toolbox?” you ask.

Simple!

Let’s compare trading to building a house. You wouldn’t use a hammer on a screw, right? Nor would you use a buzz saw to drive in nails. There’s a proper tool for each situation.

Just like in trading, some trading tools and indicators are best used in particular environments or situations. So, the more tools you have, the better you can adapt to the ever-changing market environment.

Or if you want to focus on a few specific trading environments or tools, that’s cool too. It’s good to have a specialist when installing your electricity or plumbing in a house, just like it’s cool to be a Bollinger Band or Moving Average expert.

There are a million different ways to grab some pips!

For this lesson, as you learn about these indicators, think of each as a new tool that you can add to that toolbox of yours.

You might not necessarily use all of these tools, but it’s always nice to have plenty of options, right? You might even find one that you understand and comfortable enough to master on its own. Now, enough about tools already!

Let’s get started!

Bollinger Bands

Bollinger Bands, a chart indicator developed by John Bollinger, are used to measure a market’s volatility.

Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract and when the market is LOUD, the bands expand.

Notice on the chart below that when price is quiet, the bands are close together. When price moves up, the bands spread apart.

That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger Band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.

In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger Bands to your trading.

The Bollinger Bounce

One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. By looking at the chart below, can you tell us where the price might go next?

If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.

 

Price bounces back towards the middle of the Bollinger Bands

What you just saw was a classic Bollinger Bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels.

The longer the time frame you are in, the stronger these bands tend to be. Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.

Now let’s look at a way to use Bollinger Bands when the market does trend.

Bollinger Squeeze

The Bollinger Squeeze is pretty self-explanatory. When the bands squeeze together, it usually means that a breakout is getting ready to happen.

If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then price will usually continue to go down.

 

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?

 
 
 

If you said up, you are correct again!

This is how a typical Bollinger Squeeze works.

This strategy is designed for you to catch a move as early as possible. Setups like these don’t occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart.

There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. It’s time to put this in your trader’s toolbox before we move on to the next indicator.

How to Use the MACD Indicator

MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

 

With an MACD chart, you will usually see three numbers that are used for its settings.

  • The first is the number of periods that is used to calculate the faster moving average.
  • The second is the number of periods that is used in the slower moving average.
  • And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see “12, 26, 9″ as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

  • The 12 represents the previous 12 bars of the faster moving average.
  • The 26 represents the previous 26 bars of the slower moving average.
  • The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.

How to Trade Using MACD

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears.

This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

Let’s take a look at an example.

In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.

From then, EUR/USD began shooting up as it started a new uptrend. Imagine if you went long after the crossover, you would’ve gained almost 200 pips!

There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it’s just an average of historical prices.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

How to Use Parabolic SAR

Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. Although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?

One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement.

From the image above, you can see that the dots shift from being below the candles during the uptrend to above the candles when the trend reverses into a downtrend.

How to Trade Using Parabolic SAR

The nice thing about the Parabolic SAR is that it is really simple to use. We mean REALLY simple.

Basically, when the dots are below the candles, it is a buy signal.

When the dots are above the candles, it is a sell signal

This is probably the easiest indicator to interpret because it assumes that the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns.

You DON’T want to use this tool in a choppy market where the price movement is sideways.

Using Parabolic SAR to exit trades

You can also use Parabolic SAR to help you determine whether you should close your trade or not.

Check out how the Parabolic SAR worked as an exit signal in EUR/USD’s daily chart above.

When EUR/USD started sliding down in late April, it seemed like it would just keep droppin’ like it’s hot. A trader who was able to short this pair has probably wondered how low it can go.

In early June, three dots formed at the bottom of the price, suggesting that the downtrend was over and that it was time to exit those shorts.

If you stubbornly decided to hold on to that trade thinking that EUR/USD would resume its drop, you would’ve probably erased all those winnings since the pair eventually climbed back near 1.3500.