A forex moving average?
First, do you know what a moving average is?
I sure didn’t when I met them a few years ago.
If you do know, you can skip the next section. But you already knew that, you smarty-pants-guy.
You already know what an average is.
I give you five numbers, you add them, and then divide the total by five.
Well, a moving average is just as simple.
The only difference is the initial numbers are replaced by new numbers… one at a time.
For example, what’s the average of your last three math quizzes?
If you scored 8, 9, and 7 in your last three quizzes (7 being the most recent, and 8 the least recent), then the average is 8.
You take a new quiz and scored 6.
What happens now?
Now your last three math quiz scores are 9, 7, and 6.
Thus, the average is now 7 not 8!
Notice that the question “What’s the average of your last three math quizzes?” is basically asking you for a moving average.
This is because the average will change as soon as new data occurs.
All sorts of analysts use moving averages to give them an idea of how data behaves as time moves on.
With the passing of time, new data is released. This new data is incorporated in the moving average while the oldest data is dropped.
A forex moving average example?
The 200-day MA (moving average).
As the name suggests, this indicator simply averages the closing prices for the past 200 days.
As you can tell by now, each day, this MA drops the price of the oldest day, and incorporates the price of the most recent close.
How does it look on a chart?
Now, we have only described what’s called a “simple” moving average.
There’s also another well-used type:
The exponential moving average.
Why another type of moving average?
As you can probably tell from the previous chart, the simple average is quite a lagger no?
The red line has stayed well above price action for quite a while. Hence, the simple moving average did not reflect current price action as well.
This is because a simple moving average gives the same importance or “weight” to each of its data points.
Thus, a 200-day MA will reflect an outdated view of price action.
This is still useful because you may want to see what the really-BIG picture trend is, or has been for a currency pair.
But it’s often less useful for day trading.
As such, people solve the issue by using shorter time frames.
For example, instead of a 200-day MA, you could go for a 200-hour MA.
Or you can also use a much lower number of data points.
Like a 30-day MA.
Such a forex moving average would reflect recent price action well (or better than the longer MA).
But even with these adjustments, simple moving averages still don’t adjust enough if price has moved too much recently.
Thus, the exponential moving average was born.
True to an exponential function, this type of forex moving average reacts much more to recent price action than the simple moving average.
The formula assigns more importance (or a heavier weight) to the most recent data.
I would love to say forex moving averages are pretty useless... and leave it at that.
But that’s not entirely true.
-By the way, a forex moving average is just a moving average applied to price of a currency pair (like the three charts above).
Fx traders use MAs to get an idea of the trend, whether it’s a long-term trend, or a short-term trend.
This is possible because the moving average smooths out all those candles into a nice line you can follow to identify trend.
Catch the trend bab-ey!
On the other hand, many retail traders try and use forex moving averages to see where price might be going, but this isn’t what MAs are for.
Moving averages reflect past price action, that’s it.
To know where price is going you need to know the fundamentals behind the currency pair.
And if you’re trading more short-term, you also need to know the technical support and resistance zones which might affect your planned trade.
Whether price is currently above or below a random forex moving average is good to know.
But I wouldn’t base a decision solely on this. Or even take it as an important consideration.
Still good to know, why?
Take for example EUR/USD. In the first chart we saw how far below the 200 day MA price action is.
Why is this useful?
The ECB has recently taken a more hawkish stand. The market has reacted on the expectation that the Euro will strengthen medium to long term.
Thus, it’s likely the Euro will climb back from its late rock-bottom price levels.
What’s a reasonable level for the Euro to get back to?
You guessed it.
The previous levels shown in our long-term chart are a good bet (long term).
Thus, the forex moving average gave you an idea of where price could at some point get to, based on where it has been before.
Of course, there are much more sophisticated uses of moving averages.
And each trader, who knows what he’s doing, will have a different take on this.
I just happen to share the opinion of most professional fx traders I’ve talked to.
I think this was a pretty self-explanatory post.
Forex moving averages are useful knowledge to have, but I wouldn’t hold my breath on them.
They have more advanced uses I’ve not covered here (I will at some point though).
The Forex Economist
Sep 12, 17 09:09 AM
Learn what you need to know about Forex audio squawk here.
Sep 11, 17 09:48 AM
GBP (pound) traders what can you expect from the Bank of England's MPC vote this Thursday, Sep 2017? Click to find out.
Aug 21, 17 04:41 PM
Three of the eight major currencies are commodity currency. But what is that? Which are those currencies, and how can we trade them? Click to find out.