When looking directly into the real-time movements of a forex chart, traders can sometimes lose perspective of the bigger picture of what is going on in the forex market. For example, a price movement may appear significant when compared to the current price levels of a currency pair, but may in fact be quite small when viewed in the context of the pair’s historical price movements. In order to correct the myopic view of direct chart monitoring, traders can use moving averages to add a longer perspective to their technical analysis.
Understanding moving averages
Instead of showing the current, real-time price movements of a currency pair, a moving average calculates the average price of the pair over a set number of trading days. The 30-day moving average, for example, calculates the average price of a currency pair for the last 30 days by adding up the different values that the pair had at the close of those 30 days and then dividing the total sum by 30. The 50-day moving average uses the same mathematical formula but uses the prices from the 50 most recent days of the pair. Moving averages are shown as lines running over the candles that represent current price movements on a chart, and as every new period comes to a close, the formula recalculates the new average value of the pair, moving the average line further along the chart.
As you can see in the graph above, the lines of the moving averages are much smoother than the movements of the candles showing current price movements. That’s because moving averages cancel out the “market noise” of the smaller price changes and help traders understand the trend in which the overall price of a pair is moving from a long-term perspective.
Using moving averages
Moving averages can be used in many different ways and in combination with many other tools of technical analysis, but their most common use is for finding and trading trends in the market. The smooth lines of the moving averages can help traders see more clearly whether the market is moving upwards, downwards, or simply ranging in a sideway pattern with equal ups and downs.
Because each moving average uses a different number of days or periods in its calculations, the lines of moving averages do not usually coincide on the chart. When one moving average, however, crosses over another moving average of a different period, as shown in the picture above, the crossover point can signal a change in the direction of the trend of the currency pair. Used in combination with other technical analysis tools, the signals given by crossing moving averages can help traders identify trend changes early on so as to enter or exit trades at the appropriate time.
Due to the simplicity and versatility of their calculations, moving averages are one of the oldest and most commonly used tools for trading forex, and are employed by both novice and expert traders. Although moving averages can help traders recognize trend lines and their shifts in the market, they do not eliminate the risk involved in forex trading and traders should always carefully analyse the market before deciding to open or close trades.
Mr. Lukman Otunuga is a research analyst at FXTM