Thanks to modern trading technology, today’s forex traders have many tools at their disposal to help guide their trading choices and steer them away from potentially costly mistakes.
Chief among these are a popular and relatively simple class of economic indicators known as moving averages (MAs), which are relied upon by speculators to spot both emerging and common trends, as well as discern support and resistance levels within a market.
MAs corroborate the price value of a particular instrument over a given timeframe to establish its directional momentum one way or another — thus helping traders judge whether the market is likely to appreciate or depreciate in value over the coming days and weeks.
How to Quickly Calculate a Simple Moving Average (SMA)
When calculating the most basic form of moving average indicator — the ‘simple moving average’ (SMA) — you’re essentially finding the ‘mean’ value of the security over whatever period of time it is that you’re interested in.
For a 30-day SMA, for instance, you would pick a key criterion — e.g. the closing price — of a product from 30 consecutive days, then add these figures together before dividing them by 30 to get your average closing price for that time window.
Here’s a very basic five-day SMA calculation (using a week’s worth of closing prices for the AUD/CAD cross) to illustrate:
The beauty of this simple indicator is that it can easily be tailored to specific time periods depending on your strategy and analytical needs; for convenience, many speculators opt for 50 or 200 day periods as benchmarks for assessing the long-term trajectory of an instrument.
These prices are often then plotted on a graph to create a single line — with the small-term, anomalous movements (otherwise known as ‘noise’) disregarded — so traders can pick up on the general trend more easily.
What Does an SMA Actually Tell You?
By factoring out naturally occurring inter-day volatility, an SMA allows you to gauge the general sentiment surrounding a security, and as such these indicators can be useful for identifying uptrends and downtrends at a glance.
Put simply, if the graph points upwards, then it’s increasing in value, while if it’s heading downward then the market is clearly depreciating to some degree.
It’s worth noting that longer the timeframe, the smoother the MA line is likely to be (as the day-to-day noise over periods of weeks or months is factored out), whereas a shorter-term MA tends to be more erratic visually but also more accurate overall, owing to the fact it has less data and a smaller period of time to take into account.
Consequently, some traders elect to use this discrepancy to their advantage and conduct a comparison between two separate SMA graphs, each covering different timeframes — one shorter-term and one longer-term, respectively — to get a better sense of whether recent activity is foreshadowing a change in direction from the currently established norm.
Death Cross vs Golden Cross: Common Patterns Examined
Generally speaking, a short-term SMA rising higher than the long-term is indicative of an upward movement, whilst long-term data averaging below the short term often suggests a downtrend.
In particular, there are two common MA patterns — colloquially known as the ‘golden cross’ and ‘death cross’ respectively — that investors should look out for when deciding whether to go long or short on a trade.
The golden cross refers to instances where the shorter-term (i.e. 50-day) average rises above the longer-term (i.e. 200-day) line; this is a bullish sentiment signifying high trading volumes and indicates that further gains could be around the corner for this product.
Conversely, the death cross — where the shorter-term (i.e. 50-day) average dips below the longer-term (i.e. 200-day) line — is more bearish, suggesting a downtrend is incoming and that further losses are likely in the near future.
Whilst these are undoubtedly helpful signposts, an obvious drawback is that relying on clear signals from either 50 and 200 day timeframes means that you’re going to be slow off the mark with your decisions.
Indeed, more impulsive traders may argue that waiting so long for a sell signal means you’ll have missed the peak moment to strike and are resigned (at best) to only catching the end of your window of opportunity.
There is also some debate as to whether greater attention should be paid to the more recent happenings or the more distant, albeit firmly established trends. Many speculators are convinced newer data is most reflective of current momentum, while others feel that putting emphasis on latest events biases the analyses.
Essentially, the age-old question remains: should the first or second data point carry as much weight as the 50th, 125th or even 200th?
What are Exponential Moving Averages (EMAs)?
A variant of the common simple moving average (SMA) indicator, exponential moving averages (EMAs) place more focus on recent price information and are primarily used to identify optimal entry and exit points for a given trade.
Compared to SMAs, the calculation process for these indicators necessitates some additional, fairly complex maths due to the proportional weighting systems involved.
However, the good news is that most trading platforms feature in-built tools that will do the heavy lifting for you, allowing you to view these averages with just a few clicks of a mouse to make your trading experience more convenient.
How to (Not-So-Quickly) Calculate an EMA
Here’s the full process for calculating a five-day EMA, just in case you’re interested — though as we mentioned there’s no need to get hung up on the mechanics, so feel free to skip ahead:
First off, you’ll want to find out your standard five-day SMA using the steps outlined earlier.
Secondly, you need to calculate the multiplying factor (given as a percentage) that will help weight the average in favour of the more recent data; the equation for this would be as follows:
Once you have your multiplier, you can attempt this rather intimidating looking formula to arrive at your newly skewed moving average:
As is the case with any proportional calculation, the weighting given to the most recent price will be greater for shorter-term EMAs due to the fact there’s simply less data to consider.
For instance, our five-day example uses a multiplier of 33.3%, while a 10-day average would use an 18.18% multiplier and so on; variations will also occur depending on whether the open, low, high or median prices are used as your benchmark in place of of the closing price.
Further reading: https://www.investopedia.com/terms/e/ema.asp
SMA or EMA: How Do They Differ?
EMAs and SMAs are both regularly used by day and trend traders alike as part of their technical analyses and are, in practical terms, very similar in how they even out price fluctuations for a clearer picture of the market.
Nevertheless, the two indicators have one key difference, namely how sensitive they are to changes in data; as outlined above, EMA gives more weight to the more recent data points, whereas SMAs give equal significance to all of the data inputted, no matter how long ago it was collected relative to the present day.
This is important as, by their very nature, the more recent-skewed EMAs tend to be timelier and respond to price changes at a faster rate than the more evenly weighted SMA model.
Investors therefore need to bear in mind that these MAs are (as the name suggests) only a guide and choose the type of indicator best suited to their own trading style and strategy.
Swing traders referencing EMAs, for example, should be wary of closing their positions too quickly in the event of a market hiccup that could soon subside — while scalpers relying on more neutral SMAs may be vulnerable to losses if they lean too heavily on long-term data that misses brief, important intraday spikes and lows!
