Types of Moving Averages Every Trader Should Know
Moving Averages help identify strong market trend directions. But with so many types of Moving Averages available, selecting the right one depends a lot on the time periods, your trading goals, and the current market conditions. In this article, we take a look at the different types of Moving Averages and how to use them.
What is a Moving Average in forex?
Moving Average is a technical indicator which averages out currency pair prices in a specific time period in order to accurately identify market trend reversals and support-resistance levels. The reason for calculating the average of a currency pair price is to filter out minor and irrelevant price movements. Also known as Simple Moving Average or SMA, it is calculated by adding the latest currency pair prices together and dividing the sum by the total time period.
- When a currency pair’s current price is close to its SMA price, it signals ideal entry point as the market is considered to be in a strong trend direction
- When a currency pair’s current price is far from its SMA price, it signals traders with an ideal exit level as the market is considered to have deviated and is not following a strong trend direction
Different types of Moving Averages
1. Exponential Moving Average
The Exponential Moving Average (EMA) is a technical indicator that tracks the currency pair price movements over a specific period of time by placing a greater weightage to the most recent prices. The Exponential Moving Average is also called the Exponentially Weighted Moving Average as the weights assigned make the MA highly responsive to the recent price levels. The Exponential Moving Average can be calculated in three simple steps –
- Calculate the Simple Moving Average
- Calculate the multiplier (weightage): 2/(time period considered + 1)
- Calculate the current EMA: [Closing currency pair price – EMA (yesterday)] * Multiplier + EMA (yesterday)
Where EMA (yesterday) = current SMA
- Short term traders can use the 12 or 20 periods EMA to understand short term trends
- Long term traders can use the 50 or 200 period EMA to understand long term trends
2. Double Exponential Moving Average
The Double Exponential Moving Average (DEMA) is an extended version of the EMA and responds even faster to the near-term price changes. The DEMA considers a longer time period for its calculations. This technical indicator reduces noise in price fluctuations by filtering out irrelevant and minor price moves. It, in turn, helps signal support and resistance levels in the market. Since this particular Moving Average reacts more quickly than the others, it is preferred by short-term traders, day traders or swing traders. It
- When the current currency pair prices are below the DEMA line, the line acts as the resistance level and signals traders to exit the trade
- When the current currency pair prices are above the DEMA line, the line acts as the support level and signals traders to enter the trade
Here is how you can calculate the DEMA:
- Choose a time period to consider, like 15, 20, 50 or 100
- Calculate the EMA for the chosen period
- Now calculate an EMA of the EMA calculated above to find the smoothed EMA (with lesser price noise and irrelevant fluctuations)
- Double the EMA calculated in step 2
- Subtract the EMA calculated in step 3 from the EMA calculated in step 4; this is your DEMA
3. Weighted Moving Average
The Weighted Moving Average (WMA) places a heavier weight on the most recent price point and a lesser weight on the older price levels to ensure that only recent relevant data is taken into consideration while calculating the average price level. The difference between an EMA and a WMA is that the weight alloted to each price decreases exponentially in the former and consistently in the latter. This means, in WMA, each successive weight is 1.0 weight greater than the one behind it.
- When the current currency pair price is above the Weighted Moving Average line, it indicates an uptrend and signals traders ideal buy levels
- When the current currency pair price is below the Weighted Moving Average line, it indicates a downtrend and signals traders ideal sell levels
The formula of the WMA is – WMA = [Price1 * n + Price2 * (n-1) + Price3 * (n-2)+…..Price(n)]/[n * (n+1)]/2 Where n = time period
4. Least Square Moving Average
The Least Square Moving Average (LSMA) is a curve that displays a linear regression on each bar of the chart based on the currency pair prices in the specified period of time. The linear regression determines the relationship between two forex currencies and provides traders with ideal entry and exit levels. It uses the least square method to calculate the Moving Averages and predict future market conditions accordingly. The least square method is a regression analysis that calculates the best fit line in relation to the existing data sets (currency pair prices). The sum of the least-squares is taken to find the least square regression line according to a specific time period.
- When the LSMA regression line crosses the current currency pair prices from above, it signals an uptrend and provides traders with buy opportunities
- When the LSMA regression line crosses the current currency pair prices from below, it signals a downtrend and provides traders with sell opportunities
How to calculate the LSMA regression line –
LSMA = b * t + a
b = ( nΣxy – ΣxΣy ) / ( nΣx² – (Σx)² )
a = ( Σy – bΣx ) / n Where n = total number of time period Y = currency pair exchange rate
x = the current time period
a = a constant value when the value of x is zero
b = slope of the LSMA line
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