Moving Averages - What are Moving Averages?

  • A moving average is a trend-following indicator based on past prices.

  • A moving average is calculated by a chosen number of periods and then dividing this number by the number of periods

  • Moving averages help in the smoothing out of price action.

  • Moving averages are used not only to identify the direction of the trend, but also for trade entry.

The most popular types of moving averages include the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

The SMA is the most popular type of moving average and it is formed by calculating the average price of a financial market over a chosen period of time.

 

SMA1.png

The EMA in comparison to the SMA applies more weight and significance to most recent prices and less weight to older prices in the chosen period.

EMA1.png

 

In the below screen you can find a comparison between the SMA (blue line) and the EMA (orange line).

 

EMASMA.png

 

How to use Moving Averages

There are various methods of using Moving Averages but in this article we will discuss:

  1. Using one moving average

  2. Using two moving averages

Using one moving average

When one moving average is applied to the chart then, a buy signal is provided when the chart breaks the moving average from the bottom with the body of a candlestick. On the other hand a sell signal is provided when the chart breaks the moving average from the top with the body of a candlestick.

 

SMA2.png

 

In the example above a 50 period SMA was applied to Gold. As you can see, the market first provided a buy signal, after which the market gained in value. Later the market broke the SMA from the top providing a sell signal, after which the market lost in value.

Using two moving averages

When two moving averages are used with two different periods, a buy signal is provided when the shorter term moving average breaks the longer term moving average from the bottom. On the other hand a sell signal is provided when the shorter moving average breaks the longer term moving average from the top.

twosma.png

In the example above a 50 period SMA (blue line) and a 100 period SMA (white line) were applied on the DE30 chart. A buy signal was provided when the 50 period SMA broke the 100 period SMA from the bottom, after which the market gained in value.

Keep in mind however that all indicators and oscillators often provide false signals and should thus be used with other technical analysis tools. When all the tools you’ve used indicate the same direction for the market, this increases the probability of the success of the trade.

Learn more about indicators and oscillators.

Test your knowledge with an xStation demo account

TRY DEMO