The moving average indicator is a popular indicator that is often used by beginner traders. How easy is it to use this indicator to make a profit in forex trading?

What is a moving average indicator?

A moving average is an indicator that calculates the average price of an asset over a period of time, then connects them in the form of lines. The average value can come from the opening (open), closing (close), high, low, or middle (median) price. Using a moving average indicator is the same as practicing a simple method, which is to read price movements over time. As it literally means, a moving average means using the average closing price of a currency pair that moves over time. 

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The choice of timeframe itself can be adjusted to the needs of the trader. For example, periods of 5 (1 week), 20 (1 month), 60 (3 months), and 120 (6 months). The longer the period used, the slower the line moves relative to the price. Moving averages are a way that traders can rely on to measure momentum as well as confirm trends and determine areas of support and resistance.  However, support and resistance are dynamic, as they move according to price movements. So, in an uptrend, the MA functions as support and vice versa, in a downtrend, the MA functions as resistance. 

This indicator 'smooths' the price movement over a certain time frame, so you can easily recognize the general trend or direction of price movement. As already explained, the price standard used is usually the closing price, but there are several methods that use open, high, or low prices. After knowing what it means, traders can know how to use the MA indicator to recognize trends from the discussion below. However, before continuing, fill out the GIC Trader Assessment!

How to use the MA indicator to recognize trends?

As you know, moving averages are used to measure which direction the trend will move based on the calculation of the average value of a currency pair in a certain period such as 5 days, 10 days, 20 days, to 30 days. From these calculations, you can use moving averages as a signal marker when you should take a buy or sell position.  Well, before determining when you should buy or sell from a moving average, you must first understand crossovers.

A crossover is a momentum where one moving average line crosses against the market price of another candlestick or chart or against another moving average line. Moving averages with long periods, such as 100 and 200, are usually used by large investors as a reference to determine uptrends and downtrends. If the market price position is above the long-term MA line, the momentum is called an uptrend, on the other hand, if the market price is below it, it is called a downtrend. Large investors will keep an eye on the uptrend momentum as a signal marker to open a long position.

Well, beginner traders are advised to use more than one short-period MA (5.10,20) combined with a long-period MA to help predict the direction of the trend. When one or more short-period MAs touch the long-period MAs, the trader can determine the position at that moment. If the short-term MA looks like it will crossover with the long-period MA upwards, then traders are starting to prepare to catch a buy signal.

Conversely, when some short-period MAs move will cross the long-period MA line, get ready to take a short position. Moving averages can signal traders to quickly open positions while the trend is still running. Whereas, if the MA appears static for a long time or starts to show a tendency to reverse, then it can be a sign to close the position.

There are two types of MA indicators that you need to know 

1. Simple moving average

The simple moving average indicator is the default setting of the moving average indicator. This means that when using the moving average indicator for the first time, the trading terminal will generally display the SMA as the first choice as the basis of the MA indicator. So, most likely, beginner traders will get used to using the SMA indicator over other variations of the MA indicator.  As the name suggests, the SMA indicator displays a visual line formulated from a simple average calculation. The calculation only inputs a list of prices from the highest, lowest, opening, or closing prices, and then divides by how long the period is determined, for example the following moving average formula.
  • Daily closing prices: 11, 12, 13,14, 15, 16, 17
  • First day of 5-day SMA: (11+12+13+14+15)/5 = 13
  • Second day of 5-day SMA: (12+13+14+15+16)/5 = 14
  • Third day of 5-day SMA: (13+14+15+16+17)/5 = 15

2. Exponential moving average

Exponential moving average (EMA) is a type of moving average that places greater weight and significance on the most recent data points. Although the EMA calculation is not as simple as the SMA, it gives more weight to the calculation of the average price over a given time frame. EMAs tend to be more sensitive to price movements, so exponential moving averages move a little more aggressively than SMAs.
  • SMA = total closing price for 10 days / 10
  • Multiplier = (2 / (time period + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%) EMA: {Close - EMA(previous day)} x Multiplier + EMA (previous day) 
  • The 10-day EMA applies a weighting of 18.18% to the current price. 
  • However, the 20-Day EMA will apply a 9.52% weighting to the current price (2/(20+1)=0.0952). This means that the weighting for shorter-period EMAs will always be higher for longer-period EMAs. With the addition of this weighting, the EMA can produce a 'smoother' moving average indicator than the SMA.

What are the benefits of moving averages in forex trading?

1. Smoothing price movements

As an indicator that helps smooth out price movements, one of the functions of the MA is to detect the direction of the trend. The basic theories that are the reference are:
  • If the moving average line tends to rise, it means that the trend tends to be bullish.
  • If the moving average line tends to go down, it means that the trend tends to be bearish.
However, it should be noted that if the moving average forms a hill and valley pattern simultaneously, then the trend tends to be sideways.

2. Knowing trend reversals

To determine the reversal point of a trend, you can simply see when the price breaks through the moving average. If what is broken is the short-term MA line, then the reversal is also for the short term.

3. Determining support levels and resistance

The Moving Average can be used as a psychological level for support and resistance. When the price is close to the moving average, it will often bounce back so that it seems as if the MA acts as a 'barrier' to the price movement. Therefore, if the price breaks through the moving average, this can be said to be a reversal signal.

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