Simple Moving Average (SMA)

A moving average is simply a way to smooth out price action over time. By “moving average”, we mean that you are taking the average closing price of a currency for the last ‘X’ number of periods.
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Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can make general predictions as to where the price will go.As we said, moving averages smooth out price action. There are different types of moving averages, and each of them has their own level of “smoothness”. Generally, the smoother the moving average, the slower it is to react to the price movement. The choppier the moving average, the quicker it is to react to the price movement.

A simple moving average is the simplest type of moving average. Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X.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 your simple moving average.

If you were to plot a 5 period simple moving average on a 10 minute 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.

Most charting packages will do all the calculations for you. The reason we just bored you(yawn!) with how to calculate a simple moving average is because it is important that you understand how the moving averages are calculated. If you understand how each moving average is calculated, you can make your own decision as to which type is better for you.Just like any indicator out there, moving averages operate with a delay.

Because you are taking the averages of the price, you are really only seeing a “forecast” of the future price and not a concrete view of the future. Disclaimer: Moving averages will not turn you into Ms. Cleo the
psychic!
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Here is an example of how moving averages smooth out the price action.On the previous chart, you can see 3 different SMAs. 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 SMA. This is because with the 62 SMA, you are adding up the closing prices of the last 62 periods and dividing it by 62. The higher the number period you use, the slower it is to react to the price movement.

The SMA’s in this chart show you the overall sentiment of the market at this point in time.Instead of just looking at the current price of the market, the moving averages give us a broader view, and we can now make a general prediction of its future price.

Although the simple moving average is a great tool, there is one major flaw associated with it.Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows:

• Day 1: 1.2345
  
• Day 2: 1.2350
  
• Day 3: 1.2360
  
• Day 4: 1.2365
  
• Day 5: 1.2370
  

The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358

Well what if Day 2’s price was 1.2300? 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 could have just been a one time event (maybe interest rates decreasing).

The point I’m 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.
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 Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.
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When trading, it is far more important to see what traders are doing now rather than what they
did last week or last month.

First, let’s start with an exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. These can help you catch trends very early, which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits!

The downside to the choppy moving average is that you might get faked out. Because the moving average responds so quickly to the price, you might think a trend is forming when in actuality; it could just be a price spike.With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.Although it is slow to respond to the price action, it will save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good trade.

	SMA	EMA
Pros:	Displays a smooth chart, which eliminates most fakeouts.	Quick moving, and is good at showing recent price swings.
Cons:	Slow moving, which may cause a lag in buying and selling signals.	More prone to cause fakeouts and give errant signals.

So which one is better? It’s really up to you to decide. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.

Moving Averages are one of the most popular and easy to use indicators available in Forex. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

A Simple Moving Average (SMA) is formed by computing the average (mean) price of a security over a specified number of periods. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 20-day simple moving average is calculated by adding the closing prices for the last 20 days and dividing the total by 20.
In order to reduce the lag in Simple Moving Averages (SMAs), technicians often use Exponential Moving Averages (EMAs). EMAs reduce the lag by applying more weight to recent prices relative to older prices. The shorter the EMAs period is the more weight will be applied to the most recent price.
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The Simple Moving Average (SMA) is represented in black and the EMA is the blue line.
Which moving average you use will depend on your trading and investing style and preferences.
The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer to use exponential moving averages for shorter time periods to capture changes quicker. Some investors prefer simple moving averages over long time periods to identify long-term trend changes.
Shorter moving averages will be more sensitive and generate more signals. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. However, there will also be an increase in the number of false signals. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late.

Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability. Because moving averages follow the trend, they work better when a currency pair is trending and are ineffective when a currency pair moves in a trading range.

Trend Identification and Confirmation

If the price is above a moving average and this moving average is moving up, we’re in an uptrend.
If the moving average is moving down and the price is below the moving average, we’re in a downtrend.
Here is an example using a 20 days Simple Moving Average:
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This chart shows you that moving averages help you spot the current trend easily.
You can also use 2 different Moving Averages to spot the trend. For example, if you use a 10 and a 20 moving averages. If the SMA10 is above the SMA20, you’re in an uptrend. If the SMA10 is below the SMA20 you’re on a downtrend.
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Here is another example that shows you that you can also spot a trend using 2 different moving averages.

Support and Resistance Levels
Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent.
As with trend identification, support and resistance level identification through moving averages works best in trending markets.
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This example shows you how a moving average works on a strong uptrend. The moving average was a good support area during this uptrend. This strong support area can be used as an entry point. There are even some trading systems build solely on moving averages. On this kind of systems, when the price crosses the moving average to the upside is a buy and when it crosses below the moving average is a sell. On strong trends, this kind of trading systems work well. However, during choppy markets, there are plenty of false signals for this kind of systems.