Simple Moving Average (SMA) Explained
A simple moving average (SMA) is the simplest type of moving average in forex analysis.
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.
Voila! You have the average closing price over the last five hours! String those average prices together and you get a moving average! 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.
Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!
Here is an example of how moving averages smooth out the price action.
On the 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.
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! 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.
Disclaimer: Moving averages will not turn you into Ms. Cleo the psychic!
Here is an example of how moving averages smooth out the price action.
On the 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.
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.
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.
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) vs. Simple Moving Average (SMA)
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.
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.
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.
Summary: Using Moving Averages
There are many types of moving averages. The two most common types are a simple moving average and an exponential moving average.
Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
Exponential moving averages put more weight to recent price, which means they place more emphasis on what traders are doing now.
It is much more important to know what traders are doing now than to see what they did last week or last month. Simple moving averages are smoother than exponential moving averages.
Longer period moving averages are smoother than shorter period moving averages.
Using the exponential moving average can help you spot a trend faster, but is prone to many fake outs. Simple moving averages are slower to respond to price action, but will save you from spikes and fake outs.
However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
You can use moving averages to help you define the trend, when to enter, and when the trend is coming to an end.
Moving averages can be used as dynamic support and resistance levels.
One of the best ways to use moving averages is to plot different types so that you can see both long-term movement and short term movement.
You got all of that? Why don’t you open up your charting software and try popping up some moving averages? Remember, using moving averages is simple. The hard part is determining which one to use!
That’s why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want to use them as dynamic support and resistance.
Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.
Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
Exponential moving averages put more weight to recent price, which means they place more emphasis on what traders are doing now.
It is much more important to know what traders are doing now than to see what they did last week or last month. Simple moving averages are smoother than exponential moving averages.
Longer period moving averages are smoother than shorter period moving averages.
Using the exponential moving average can help you spot a trend faster, but is prone to many fake outs. Simple moving averages are slower to respond to price action, but will save you from spikes and fake outs.
However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
You can use moving averages to help you define the trend, when to enter, and when the trend is coming to an end.
Moving averages can be used as dynamic support and resistance levels.
One of the best ways to use moving averages is to plot different types so that you can see both long-term movement and short term movement.
You got all of that? Why don’t you open up your charting software and try popping up some moving averages? Remember, using moving averages is simple. The hard part is determining which one to use!
That’s why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want to use them as dynamic support and resistance.
Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.
Quiz Time!
Moving Averages
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It may be a simple concept to grasp, but have you mastered moving averages? Let’s put your forex knowledge to the test!
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