One of the best ways to evaluate the movement of a currency exchange rate or an index is to evaluate it using a moving average. A moving average is an average that changes with time. The benefit of using a moving average is that it smooths some of the choppiness of that can occur when you only analyze the price movements of an exchange rate. You can use a moving average to help you determine support and resistance levels, as well as market trends. A moving average can also help describe momentum, as well as whether an exchange rate is confined to a range.
What is a Moving Average?
A simple moving average (SMA) is an average of a certain number of periods. You can calculate a moving average on your own or but an easier process is to have the Meta Trader 4 trading platform that is offered by Rakuten Securities Australia calculate moving averages for you. The 50-day moving average of the USD/JPY (red line) is shown by calculating the average of the last 50-days. On day 51, the first day of the average is dropped. The historical 50-day moving average of the USD/JPY is shown versus the historical movements of the exchange rate. What you probably will notice is that the moving average is much less choppy, and does not whipsaw in a range as does the underlying exchange rate.
Moving averages that are calculated on the MT4 trading platform are very flexible. You can change the number of periods used in the calculation to any number. The shorter the moving average, the more influence it is by the latest prices. You can see in the chart of the USD/JPY that the 10-day moving average (blue line) is choppier than the 50-day moving average and appears to be more influenced by the different changes to the underlying USD/JPY exchange rate.
Types of Moving Averages
You can evaluate a moving average on any period. This includes daily, weekly, monthly, or even intra-day charts. You can also look at different types of moving averages, where the calculation is different. For example, many traders use an exponential moving average as opposed to a simple moving average.
An exponential moving average (EMA) is also a tool that is calculated by MT4 software. An exponential moving average is used because it reduces the lag by applying more weight to recent prices. The weighting that is applied to the most recent price will depend on the number of periods that are used to develop the moving average. An exponential moving average is calculated in 3-steps.
- Calculate the simple moving average
- Calculate the weighting multiplier
- Calculate the EMA using the price, the SMA, and the multiplier
Since current price movements have a greater impact on the EMA than the SMA, many traders like to use it when they are creating studies that involve a moving average.
What is a Moving Average be Used For?
Several studies use moving averages to evaluate price movements. Some of the more notable include:
- Support and Resistance
- Trend Following
- Momentum
Support and Resistance
The changes to a currency exchange can be gauged by levels that provide support and resistance. Support is a price level that experiences demand where prices have a difficult time moving lower. Resistance on the other hand acts as a cap, where prices have a difficult time moving higher. You can use a moving average to define the level of support and resistance. You can see that the 50-day moving average (red line) shows periods of support as well as resistance.
Trend Following
A moving average can also be a guide to the underlying trend of a currency exchange rate. A trend is defined as the general direction an exchange rate is taking during a specified period. Trends can be both upward and downward sloping and related to bullish and bearish markets. You can see from the chart of the USD/JPY that the 50-day moving average (red line) is upward sloping from October 2019 to March of 2020 and then downward sloping from March 2020 to June 2020.
One of the most popular was to signal an upward or downward trend in an exchange rate is to use a moving average crossover strategy. A crossover strategy uses a short-term moving average and a longer-term moving average. For example, in the chart of the USD/JPY when the 10-day moving average crosses below the 50-day moving average, a short-term downtrend could be in place. When the 10-day moving average crosses above the 50-day moving average a short-term uptrend could be in place.
A moving average is a lagging indicator. Since it is calculating how prices moved in the past, the signals that a moving average crossover indicates is that a trend is in the process of taking place. In many instances, traders will use exponential moving averages instead of simple moving averages to signal a trend sooner.
What you can also see from the chart of the USD/JPY is that the moving average crossover strategy can work very well when a market is trending, but can generate a lot of false signals when an exchange rate is trading sideways.
Momentum
A moving average can also help determine momentum. One of the most popular momentum indicators, which is found on the MT4 platform is the Moving Average Convergence Divergence index (MACD). The MACD uses three moving averages to calculate momentum. Momentum is defined as the change in two moving average.
The default is the 12-period exponential moving average and the 26-period exponential moving average. The MACD calculation subtracts the 26-day moving average from the 12-day moving average which is called the MACD line. This difference is compared to the 9-period exponential moving average of the MACD line which is the MACD signal line. When the MACD line crosses above the MACD signal line a buy signal is generated. When the MACD line crosses below the MACD signal line a sell signal is generated.
The Bottom Line
A moving average is a versatile tool that can be used in many studies including support and resistance, trend following, and momentum. You can use any period moving average on daily, weekly, monthly and intra-day prices. There are also different ways to calculate a moving average. The simple moving average and the exponential moving average are the most popular. Software that is provided by Rakuten Securities Australia calculates nearly all the moving averages you need to trade the currency and index markets.