“The Dow Industrial Index is moving below the 200 day moving average.””Gold is looking to move higher now that the 50-day average is trading above the 100-day.” These are some common phrases that have recently surfaced in market interviews and financial commentary. But what does it all really mean? Market technicians are referring to none other than the moving average of prices. One of the oldest and simplest technical tools out there, traders of all levels refer to moving averages in analyzing price movements and potential trade opportunities. By using at least three key interpretations, market participants can fully exploit the moving average in isolating windows into nascent trends and trade setups.

Some Quick Definitions

First, for simplicity’s sake, this article will be referring to moving averages as simple moving averages (SMA). These moving averages are the most commonly referenced in charting, however, are not the only ones that are applied.

Simple Moving Average (SMA): A moving average that is calculated by simply adding all closing prices in a certain number of time periods. The number is then divided by the number of time periods chosen.

Exponential Moving Average (EMA): Similar to the Simple Moving Average calculation, the exponential average is different in that more weight is given to the latest or most recent set of data. For example, in a group of ten closing prices, more of the average’s weight will be placed on the last 3 or 4 prices.

Weighted Moving Average (WMA): Slightly more complicated, the weighted average assigns a heavier bias on recent price action (similar to the EMA). However, the difference lies in the actual calculation of the weighting. For example, taking 10 closing prices, the most recent price is multiplied by 10, the next recent is multiplied by 9 and so on. Once done, the results are then added and then divided by the sum of all of the multipliers – in this case would be 55 (10+9+8+7….1).

Support and Resistance Barriers

Now with the definitions over and done with, the simplest interpretations are to use the moving averages as support and resistance. Compared to standard trendlines and levels, moving averages are also essentially a picture of previous prices. As a result, a break or test of these prices can prove to be an indication of whether or not a current trend will continue on or fail and turn.

In the example below, a 200-day moving average is applied to daily price action in the GBPUSD currency pair. Used as trendline support, the simple moving average actually acts as the support for a long term channel. Here, a trader could place buy orders for the pair, knowing that as long as the price action remained above the 200-day SMA, the trend would continue higher. One such buying opportunity comes at point X. At this point, the trade would be entered at 1.97552, located on the moving average. Riding the position higher, the opportunity turns profitable as the trade tops out at 2.1179, approximately 1,400 pips later.

Moving Averages Holding Support

Directional Bias

Aside from being referenced as support and resistance, moving averages can also be used to show market bias, helping the trader to gauge potential price direction. Instead of using just one simple moving average, market technicians will reference two moving averages in order to confirm a positive or negative bias in the market. This tool can help traders that are looking for shifts in momentum, keying in on a turn in the market.

One such example is presented in the USDCAD currency pair below. Once again analyzing a daily chart, we see a currency pair that has been relatively range bound for sometime at the end of 2007. The shift doesn’t come until mid 2008, when the 50-day moving average (purple line) crosses and rises above the 200-day moving average (light blue line). Using simple support and resistance levels, a trader can target a long term buy trade, holding onto the position as long as short term prices (50-day average) remain above longer term prices (200-day average). This way, the trader is making sure that more recent price action is advancing when compared to older more historic prices. Not a bad way to “buy and hold”.

A new trend breaks consolidation

Taking a closer look

Using Moving Averages with an Oscillator

In one last application, market trend bias can be used in tandem with an oscillator in order to better interpret the market. These additional oscillators can include the MACD (moving average convergence divergence), Slow Stochastic or Relative Strength Index oscillators. Used together, the trader can obtain a clearer picture of what is happening as compared to applying only simple moving averages. In most instances, SMAs are used as support to initial readings given by the oscillators. Below is a great example of this idea. A clear cut downturn is forecasted using a longer term Stochastic oscillator reading in the NZDUSD currency pair. Notice how the price action breaks below the 50-day (blue line) and 200-day (orange line) moving averages. The breakdown triggers a sell signal through the Stochastic, which is later confirmed as the 50-day average, sinks below the 200-day average. As a result, a trader who is short, can remain short as long as the price action remains below the moving averages.

A good time to go short

Conclusion

Although a bit tricky, moving averages can be applied to any chart and give a clearer picture of what is going on in the market. And it’s not hard to see why currency traders at every level use this tool in one way or another – whether to confirm a trend or look for the next turn. Ultimately, with just a little practice, moving averages can really help in making the trend your friend.

Tags: Simple Moving Averages

This entry was posted on Wednesday, July 29th, 2009 at 11:45 pm and is filed under British Pound, Canadian Dollar, Currency Trading, Euro, Feature Articles, US Dollar. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.