Hi again all, well there have been quite a few newcomers into the chat area of Marketiva asking a questions something like "How do I play this game?". After the barrage of "it is not a game" replies, usually the talk moves to setting the user up with Moving Averages on their charts (usually by peterb). So, to make his explanations easier, here is the basic rundown of what moving averages are and what they are for from a beginners perspective.

Most people would realise that an "average" is simply the sum of numbers divided by the number of numbers. So the average of 4,7,4,6,4 would be 5 (4+7+4+6+4 = 25 divided by 5 = 5). So a "Moving Average" is simply an average of a series of numbers, but over a period of time. So let's say we have a series of 10 numbers, a "5 Moving Average" would be the average of 5 of those numbers, but which ones? Let's look at an example:


Above are 10 numbers, from 1 to 10, if you take the the first number (1) as day 1, and the last number (10) as day 10, then we have a 10 day history of numbers. If I ask you what is the 5 period Moving Average on day 2, your answer would have to be "1", as there is only one day of history available, that being day 1. How about if I asked you what is the 5 period Moving Average on day 6?, then the answer would be "3 stupid", because you have added the last 5 days of history,and divided it by 5 (1+2+3+4+5=15 divided by 5 = 3).

Now what about if I ask you on day 10 what the 5 period Moving Average is? I would hope that, firstly you wouldn't tell me to stop asking you stupid questions while you are trying to make money, but you would also say "7" because you have added the last 5 days of data together (9+8+7+6+5 = 35 divided by 5 = 7). So you can see, as you move along the series, the old ones (more than 5 periods back) are dropped, and the new ones are added. This is what is known as a Simple Moving Average (SMA), and is the easiest to explain in laymans terms. It's simplicity is essentially it's downfall for some, as each new number effects the average twice, when it comes in, and when it drops out, which can distort the results, especially if the number is huge. Imagine we put the number 100 into that series of numbers, when it came in, it would push the average really high, and when it dropped out, it would push the average down sharply.

To counter this effect, another type of Moving Average was developed, this being the Exponential Moving Average (EMA) which doesn't drop the old ones as quickly, but slowly squeezes them out over time, this has the effect of smoothing the average out and to eliminate some of the inherent lag that is in a Moving Average (as it is looking back, not in the future, so it is "re-active, not pro-active"). Now I am not going to even try to explain that one, cause well, I can't, but just know the common belief is that an EMA is more responsive and accurate than a SMA and are probably the most talked about so if it is good enough for them, it is good enough for me.

So you're probably thinking "ok that's all pretty boring, just tell me how to make money with them", well here is the theory. Lets start with a pretty picture:


This is a typical looking candle chart of the EUR/USD with two Exponential Moving Averages. The green line is a 10EMA, or 10 period Exponential Moving Average, the red line is a 30 EMA, or 30 period Exponential Moving Average. Now the higher the number, the further back in time it looks, which means the most recent value has less immediate effect cause we are averaging a greater amount of numbers. This is sometimes referred to as a "slow line" as it moves, bends and turns slower. You can see the 10 EMA moves in sharper turns and react's to price changes quicker as the last value has a greater effect on the numbers being averaged due to there being less of them.

So how do we use them? Well the lines serve to "smooth" or "average" the price direction, so if a Moving Average is moving down, then the average trend for that period is down, and of course it works the other way too. Above you can seem a few up and down arrows, these signify when the average lines "cross over" each other during the day. What does it actually mean in terms of the market place though?, if a short term EMA, such as the EMA 10 in this case moves below the mid or long term EMA, such as the EMA 30, it means current prices are on average below prices of 30 periods ago, this then is taken as it being in a downtrend, if it moved above than the opposite applies.

I have marked the crossovers in the chart with arrows, down arrow for when the 10 EMA crosses below the 30 EMA, and an up arrow for when the 10 EMA crosses above the 30 EMA. Some traders use these cross overs to enter trades, entering Long (Buying) at the up arrows, and Short (Selling) on the down arrows. This can be a good tool, but remember, the EMA lines are looking back in time, not forward, and so cross over after the price change itself, which means it could be too late if the move isn't great, especially on short term charts. Another way to use them is to use them as a "filter indicator" which means combine them with another indicator that might indicate a turning point to confirm the strength of a movement. If you have an indication the price is going to drop, and the EMA 10 crosses below the EMA 30, that should give you some mroe confidence on taking that trade.

How you use them is really up to you, and what periods you use for them also is up to you, and quite often depends on the time frame they are being used on. It will also depend on how long you are wanting to hold a trade, no use using a EMA that is looking back 2 weeks if you only want to hold it for 1 hour, as it will mean nothing and will turn way too slowly.

One last thing, look at the yellow areas above, here you can see where the EMA 10 moved to cross the EMA 30 but failed, this can catch many investors out, and if you have not placed a stop loss, quite often your losses can be large, so be careful and find other ways to confirm your suspicion of the move.

I hope this helps you all on the path to riches, Moving Averages are a great tool that should help you all in identifying the trends and turning points of a market. Remember "The trend is your friend".

Happy trading!

This entry was posted on Thursday, September 15, 2005 at 3:00:00 PM. You can skip to the end and leave a response.