3 Ways to Use Moving Averages in Your Trading

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This article will discuss a specific type of moving average known as the ‘Exponential Moving Average’ (EMA). We’ll also look at an easy-to-use trading tool called the ‘Exponential Moving Average Indicator’ that uses this method to assess trends within the Forex market.

So What is An Exponential Moving Average?

An essential type of tool for assessing trends is the moving average. We use moving averages to smooth out variations in data, to better discern the underlying trend. They do this by looking back at a recent number of data points, and then calculating some form of average of the values. There is more than one way to calculate an average though, and there are several types of moving average.

The most straightforward method is the Simple Moving Average (SMA), which considers all price values equally, and takes the mean as the average. Other common types of moving average assign a weighting to different price values, favouring recent prices more heavily than older prices. This is the way in which the exponential moving average model works, with the amount of weighting assigned to a price decreasing exponentially as we go backwards in time.

What is a Exponential Moving Average?

It is fairly difficult to provide a satisfactory exponential moving average definition without getting into the specifics of the calculations involved. A broad EMA definition is: a smoothing technique arrived at by adding a portion of the current price, to a portion of the value of the previous moving average. To properly get a handle on what is going on though, we need to get our hands dirty and look at the maths. So let’s go ahead and roll up our sleeves.

How to Calculate an Exponential Moving Average

We calculate an EMA at time – t – using the exponential moving average formula as follows:

  • EMAt = α x current price + (1- α) x EMAt-1

Where ‘α’ is a smoothing constant with a value between 0 and 1, EMAt-1 is the EMA for the previous period. You can see from this that calculating the EMA for a given point in time requires us to have performed prior calculations, to know the EMAs for previous periods. For a daily EMA, we derive the current value from the prior day’s EMA, which in turn we derive from the day before that, and so on.

In other words, there are some other steps involved. The first of these is to obtain a starting EMA value for the first period in our window. We also need to determine our smoothing constant. Probably the best way to illustrate the process of how to find an exponential moving average is to look at a specific example.

Exponential Moving Average Example

To keep the example simple, we are only going to use a few data values. Let’s look at how to calculate an 8-day EMA from some sample values. The table below shows the values involved in calculating the 8-day EMA.

Day

Sample Price

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8-day SMA

α

8-day EMA

We need a moving average value for Day 1 to begin. For this, we’ll use a simple moving average as our initial value. This is the sum of the previous ‘n’ values, divided by n. On the ninth day, we have our starting value, which is the SMA of the previous 8 day’s prices. Though the SMA is only required for the purpose of providing us with our starting value for our EMA calculations, we have included a column of SMA values.

That way, you can see the comparative values of the exponential average vs the simple moving average. We also need to use a smoothing factor. This is governed by the number of periods in the EMA. Specifically, the equation for the smoothing value is as follows:

Another way of describing what the calculation method is doing is to say that the EMA is by looking back at past values, and then discounting their weights by a factor of (1-α) per period. We can see from this that another, fuller name for the method is an ‘exponential-weighted moving average model’. Exponential moving average forecasting is a widely-used method of time series modelling in business because it works well under a large range of conditions, while also being fairly simple to calculate.

It’s common for management to make decisions based on projections of future business metrics. Such projections are often derived from EMA data models. A moving average forecasting example might include looking at previous sales data, exponentially-smoothed in order to make projections for future sales. In a similar way, professional traders use EMAs to smooth previous price data in the hopes of tapping into an ongoing trend.

In our calculations above, we only went back to include a small number of previous data points. An EMA will be more accurate the further you go back; however, and ideally, you want to be including much larger amounts of previous EMA values. Any platform worth its salt will run the exponential moving average algorithm for you, so that you don’t need to worry about the complexity of the calculations. Let’s now look at how to use the MetaTrader 4 EMA indicator.

EMA Indicator in MetaTrader 4

The Exponential Moving Average Indicator comes with the MT4 download, as one of the core tools bundled with the platform. As you can see from the image below, the Moving Average indicator is listed as one of the Trend indicators within MT4:

Source: MetaTrader 4 – How to select the EMA in MT4

The MA method field defines the type of moving average that you’ll add to the chart. In the image above, we’ve naturally selected Exponential. Apart from cosmetic choices, the two EMA settings are ‘Period’ and ‘Shift’. Of these, the more important setting to choose is the exponential moving average period. The larger the period, the smoother the chart.

The smaller the period, the more responsive the EMA line will be in responding to the price. Some typical EMA settings are 10 and 25 periods for faster, more responsive curves; 100 and 200 periods for very smooth, slow-moving curves; and 50 periods for an intermediate curve.

Obviously, just how long those trends are will be dictated by the time frame of your chart. The shift setting works by offsetting the EMA curve along the x-axis by the number you specify. The default value of 0 for the shift setting is a good place to start. The image below shows a 16-period Forex EMA indicator added to an hourly EUR/USD chart:

Depicted: MetaTrader 4 – price data from Admiral Markets – hourly EUR/USD chart – Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

The EMA chart indicator appears as a dotted green line with the settings we have chosen. Can you see how the EMA indicator line is much smoother than the movements of the underlying price? It still traces the general movement of the market, but it effectively filters out price noise, showing us a clearer indication of the overriding trend.

It is the slope of the MT4 EMA indicator that guides us to the trend. Notice how we get a sustained uptrend after the price breaks above the EMA line? This is one of the key aspects of how to trade with the EMA Indicator – price crossing above the EMA can provide a trading signal.

Exponential Moving Average Trading Strategy

An even more effective way of reading an exponential moving average cross is by using a double exponential moving average combination, one short-term and one-long term. This exponential moving average crossover strategy creates a trading signal when the shorter EMA crosses the longer one.

For example, a long-term trend trader might use a 25-day EMA as the shorter average and a 100-day EMA as the long-term trend line. With this exponential moving average strategy, the trader would then buy when the 25-day EMA crosses above the 100-day EMA, and sell when the 25-day EMA crosses below the 100-day EMA.

Using an EMA With Other Indicators

Moving averages have more than one use. In fact, they are often paired up with other indicators in order to make trading systems. For example, a typical use can be as a trend filter for a breakout strategy. Consider a trend-following Bollinger Bands/exponential moving average breakout system – here, we would use the Bollinger Bands to provide our trading signals.

The Bollinger Bands plot a volatility envelope above and below the price on a chart. If the price breaks beyond the envelope, we would take it as a signal to trade in that direction – but only if our trend filter, which is a short-term EMA and a long-term EMA line, agreed with the direction. So for a breakout above the upper Bollinger Band, it would be a buy signal, and we would need the short-term EMA to be above the long-term EMA for us to follow the signal.

Conversely, for a breakout below the lower Bollinger Band, we would sell, but only if the short-term EMA was below the long-term EMA. There’s a lot of combinations that have been and can still be dreamt up – and the wider the selection of tools at your disposal, the greater the scope for invention. MetaTrader Supreme Edition is an plugin for MetaTrader 4 and MetaTrader 5 that offers a huge expansion in the range of indicators and trading tools at your disposal. It’s free to download, so why not try this cutting-edge upgrade?

Conclusion

We have seen how we can smooth price data using an exponential moving average. Not only does this indicator help confirm the trend, but it can also help to inform you when to trade, as we saw with the MT4 EMA crossover indicator strategy. As with all moving averages, you need to be aware that an EMA responds with a lag.

Because it utilises past data, the price will always be on the move before the EMA starts to move. Generally speaking, an EMA will respond quicker to newer data compared with an SMA, as it assigns more weight to more recent prices.The exact curve characteristics are governed by the period you choose, of course.

A great way to determine what the best exponential moving average settings for your own trading style are is to go ahead and test them in a demo trading account. Because demo trading is risk-free, it allows you the freedom to tinker with the settings until you can find the perfect mix for you. We hope that you enjoyed this discussion of trading with exponential moving averages.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

How to Use Moving Averages to Find the Trend

One sweet way to use moving averages is to help you determine the trend.

The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it signals that price is in a general UPTREND.

If price action tends to stay below the moving average, then it indicates that it is in a DOWNTREND.

The problem with this is that it’s too simplistic.

Let’s say that USD/JPY has been in a downtrend, but a news report comes out causing it to surge higher.

You see that the price is now above the moving average. You think to yourself:

“Hmmm… It looks like this pair is about to shift direction. Time to buy this sucker!”

So you do just that. You buy a billion units cause you’re confident that USD/JPY is going to go up.

Bammm! You get faked out!

As it turns out, traders just reacted to the news but the trend continued and price kept heading lower!

This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.

In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa. For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:

Above is a daily chart of USD/JPY. Throughout the uptrend, the 10 SMA is above the 20 SMA.

As you can see, you can use moving averages to help show whether a pair is trending up or down. Combining this with your knowledge on trend lines, this can help you decide whether to go long or short a currency.

You can also try putting more than two moving averages on your chart. Just as long as lines are in order (fastest to slowest in an uptrend, slowest to fastest in a downtrend), then you can tell whether the pair is in an uptrend or in a downtrend.

2 Ways to Use Moving Averages

Indicators can be very handy tools for the CFD trader. They can assist in simplifying developments on a chart. This way traders can instead focus on placing the trade and managing their risk.

After all, no system or strategy can perfectly predict future movements on a chart, right? The goal of technical analysis (and trading in general) is to find setups that may offer favourable probabilities of success. This is like trading in the direction of the trend; if a market is trending higher, the trader looks for ways to efficiently buy into that market. While the future is uncertain, that trader can look at the bigger picture of that market to say ‘if the bias (trend) that’s been seen is going to continue, then I should be in an optimal position by being long in the market.’

This is the value of indicators: They can help to simplify technical analysis so that traders can generate trade ideas that may offer attractive probabilities and setups . Of all of the available indicators, one of the simplest is also one of the most versatile and that is the Moving Average. In this article, we’re going to discuss two different ways to trade with moving averages.

How To Calculate the Moving Average (MA)

The moving average equation is the last X periods’ closing prices added together, and then divided by the number of periods . This provides a ‘smoothing’ effect for price action; where each individual candle may be higher or lower, but the moving average value will smooth these near-term fluctuations by averaging the price of the current candle with prices of previously-printed candles.

The benefit here is one of simplicity. Because if a market is trending higher, often accented by ‘higher highs’ and higher lows,’ the moving average will reflect these higher prices while also tilting upwards. And this leads us directly into our first usage of Moving Averages.

Moving Averages as a Trend Filter

This is probably the most common usage of moving averages amongst traders. Because moving averages can assist in detecting trending formations, traders can look to current price’s relationship to the moving average to identify a trend. The chart below depicts this usage of Moving Averages:

Moving Average Filters can help traders generate a trend-side bias

Traders can use ‘tight’ filters, or more ‘loose’ variations. And the differentiation can be huge based on how aggressively a trader wants to speculate in a market. Short-term variations of moving averages, like 3 or 5 periods, are going to mirror current price significantly more than a ‘looser’ moving average of 200 periods.

With a tight or shorter-term filter, traders will be able to more aggressively enter into new trends. The downside is that the shorter-term being used for the filter will entail more noise with lower probability of each individual trend coming to fruition.

More loose filters will be slower to identify new trends, but will generally help traders to prevent the additional ‘whip’ that may be seen from tighter variations.

Which is better? That really depends on the individual market being traded and the rest of the strategy being employed by the trader.

For most cases of the moving average in the strategy is being assigned solely as a trend filter, longer-term or looser filters can work better because they leave more flexibility to the trader in addressing the trend. A common example of this type of filter is the 200-Day Moving Average. Surely, the 200-day moving average isn’t going to catch every trend at the early stage, but it will also help traders avoid much of the whipsaw that would be seen as a result of a tighter filter.

Picture for a moment an up-trending market turning into a down-trend (pictured below) as we’ve seen recently in Oil. After the high was set, as traders began pricing in lower-lows and lower-highs, it took quite a while for prices to hit and then move below the 200-day moving average. A faster version would have picked this reversal up far quicker as shown in the chart below:

However, the downside of the faster filter is that periods of congestion or ‘whip’ in the market can throw off numerous misleading signals. The chart below shows how a tighter filter would have proved challenging to the trader as Oil congested before resuming the down-trend. Notice how the looser filter would have allowed the trader to continue pressing the short-side of the trade.

There is no right or wrong answer for how tight or how loose an individual filter should be. In the efforts of consistency and synergy amongst strategy tools – traders should look at looser variants. Common inputs for this type of filter would be 50, 55, or 100 periods of the chart that’s being analyzed (with appropriate trigger being placed on the same time frame).

Moving Averages as a Positional Trigger

Once a trader has identified the trend or the direction of a prevailing bias in the market, they then need to decide how to enter in that market.

This is where many traders will add something like an oscillator of the RSI, MACD, or Stochastic variety. This could work out well, as it allows the trader to take a diametric view of a market: The trend filter to identify momentum while the trigger looks at overbought/oversold.

The potential problem that comes with using an oscillator is that overbought or oversold don’t necessarily mean much to a market. After all, the strongest trends (the ones you want to be in) will continue moving higher regardless of how overbought a market is. If there is good information that’s compelling traders around the world to move prices higher, they likely won’t care very much whether or not RSI gets oversold.

Moving averages can, once again, be extremely helpful for this portion of strategy logic.

If a trend is moving higher – then the trader wants to buy, right? Sure, there could be times in an up-trend when a short position may work out – but remember, this isn’t a prediction game, it’s about probabilities. If the trend is up then the trader wants to buy to get those probabilities in his or her favor. The trend filter can help the trader accomplish this.

If the trader wants to buy, then how do they want to do it? Well, we can employ the same logic that we have all been taught since we were children: Buy low, and sell high. You’ll hear this regurgitated across markets and trading education, but what in the world do the terms ‘low’ and ‘high’ mean? Surely, these are relative metrics. If a market is trending higher, what could be considered ‘low’ right now would have likely been considered ‘high’ earlier in the trend.

Because of the responsive relationship of the moving average to current price, traders can incorporate a moving average trigger in the effort of ‘buying low and selling high.’

To use a moving average as a trigger, one simply needs to observe price crossing the indicator to see a signal. When price crosses above a moving average trigger, that’s a signal to go long; and when price crosses below, that’s a signal to go short.

The Moving Average Trigger offers the trader a signal with according crossovers.

As you may notice from the above chart, there can be quite a few signals when trading with a moving average trigger. Trading this in isolation, as in not using a trend-filter, is a surefire way to get chopped up in ranging or congested market. If prices are congesting, and not trending, buying each time price moves above or selling each time price moves below will often see traders chasing their own tails.

Instead, traders should look to use the moving average trigger with a positional bias; as in they’ve already decided that they want to buy because prices are staying above the longer-term moving averages, indicating an up-trend. And then when price crosses back above the shorter-term moving average (the trigger), the trader can look to open the position.

And when price crosses back below the moving average trigger; the trader can look to close the long position. It’s important to note the relationship here… if prices are above the longer-term moving average, indicating an up-side bias; the trader does not trigger short positions when prices move below the moving average trigger.

Rather, traders can wait for price to cross the moving average in the direction of the longer-term bias before re-entering long. The picture below will show the proper usage of a moving average trigger. As long as the trend continues, the trigger can continue to offer favorable entries in the direction of this bias.

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