The moving average is one of the most popular indicators used by technicians.
We have three different types of moving average:
the simple moving average, the weighted moving average and the exponential moving average.
The simple moving average is just the average of all the prices selected.
For example, let's say that we want to calculate the last five closing prices for euro-dollar.
The first candle closes at 1.15. The second closes at 1.17. The third
at 1.1550; the fourth at 1.16 and the fifth at 1.1650.
So we need to do 1.15 + 1.17 + 1.1550 + 1.16
+ 1.1650 and everything must be divided by five.
And we have 1.16.
The general formula is a summation with K that goes from one to n of P K and everything divided by n,
where n is the number of candles that we decide to analyze.
So what if we want to analyze last five candles?
This simply means that n is equal to 5
and you need to add all the prices, starting from the first one, where k is equal to 1, till K equal
to 5,
that is last candle's price.
Once you add all the prices, you divide by five because n is equal to 5.
Don't worry this doesn't mean that you have to get a degree in mathematics to use the moving average.
I have introduced the formula just to let you understand better what I'm going to explain later on.
Anyway why do we call this indicator moving average and not just average?
This is because every time that a new candle is formed, this replaces the oldest candle that was included
in the calculation of the average.
So let's take back the previous example.
These five prices refer to the closing prices of the last five candles.
When a new candle is formed on the market, the moving average will automatically replace the oldest
price with the new one.
So the moving average will not include 1.15 any more in this calculation.
But we will have the new price.
So let's say that the new price is 1.18, the new moving average level then will be
1.17 plus 1.1550 plus 1.16 plus 1.1650 plus
1.18 and everything is divided by five and we get 1.1660.
So the moving average is moving up after the formation of the last candle.
That's the reason of the name moving average and not just average. For the simple moving average, every
price contributes in the same way.
So each price contributes one fifth of the total moving average that we have calculated.
This means that if we choose a small number of candles to calculate the simple moving average, the indicator
will be very sensitive to every recent price action.
This is good from one side because you can have a better understanding of recent price movements but,
from another side, it is very easy to get caught in anomalous price movements that will give you false
signals. To try to avoid the false signals,
you can try with a longer term simple moving average, that has a smoothing effect, but it will be less responsive
to recent prices.
So you need to try to balance the advantages and disadvantages of having a short term and long term
moving average. If you want to choose a long term moving average but you are afraid that you are
not giving much importance to recent candles,
you can have a look at the weighted moving average.
This kind of moving average assigns different weights to each price
and the most recent prices are weighted more heavily than older prices.
You can also choose how to weight the data but I'm not going into it,
otherwise this will become a course about technical indicators. Last type of moving average is the exponential
moving average, that can be considered a special type of weighted moving average. The exponential moving
average assigns progressively smaller weights to each of the past prices. Each weight is exponentially
smaller than the previous weight.
That's the reason of the name exponential moving average
and this is probably the most used one by Forex traders. Before having a look at how to use the moving
average with the candlesticks,
we need to answer to three questions.
What type of moving average are we going to use?
How many candles do we include in the calculation? How to use the moving average? The type of moving average
that you're going to use is a very personal choice. For this course,
I would say that the moving average that makes more sense is the simple moving average.
This is simply because candlestick patterns already focus on last candle formations on the market.
So there's no need to use an indicator that puts more emphasis on recent price actions.
Anyway I strongly recommend to try all the different types of moving average,
so you will know better which one suits your trading strategy and which one helps you more to understand
the market. I use the simple moving average when I analyze my long term investments on a monthly chart and
I use the simple and the exponential moving average
when I study other timeframes. The number of candles is another personal choice.
I would recommend not to go under five candles and not to go over 200 candles.
I personally like a period of 24 candles.
Why 24?
I consider 24 a magic number in forex trading.
It fits almost all the time frames.
If you use a 15 minutes time frame, 24 candlesticks will give you information about last six hours; if you use
the hourly chart, you monitor what happened during the last 24 hours.
If you use a four hour chart, you have 96 hours,
that is exactly four days.
So I love the number 24 in forex trading because it seems to fit perfectly every time frame.
If I also want to have a long term moving average, I choose 120 as a period.
Now let's face the most important question: how to use the moving average?
There are hundreds of techniques that involve the moving average. If you search for them on google, you
will find a lot of them.
But I can guarantee that they will be effective.
I will show you here the most important techniques to try to use this indicator together with the
candlestick patterns to understand better the market.
First one is comparing the price with the moving average.
This is very simple.
If the price is over the moving average, we can assert that the market is in an uptrend.
If the price is below the moving average, we will say that the market is in a downtrend.
This is obviously very general because it doesn't include two necessary factors like the time frame and
the period of the moving average.
It wouldn't make any sense to say that the market is in an uptrend if we are studying the moving average
on a five minutes chart with a period of five candles. If you want to use this technique, my suggestion
is to use a time frame of one hour or higher and a period of 24 candles or higher.
The second strategy is using the moving average as support and resistance levels.
Well, this doesn't need further explanation. I think it's quite self-explanatory.
Last trading strategy I want to show you,
is called the cross over and it needs two moving averages. One will be a short period moving average
and the other will be a long period one. When the short term moving average crosses above the long
term moving average,
we have a bullish signal; when the short term moving average crosses below the long term moving average,
we have a bearish signal.
Why does this make sense?
Because we have said that a moving average that includes a smaller number of candles
is more sensitive to recent price action.
So when the short term moving average crosses the long term moving average, it is showing that recently
the price is deviating from the long term action.
So it can initiate a new trend or simply a retracement from the main trend. Ok, I stop here to be boring with
the theoretical explanations and I'm going to show you how to combine moving average and candlestick
patterns to have a better view of the markets.