Moving average serves as the best indicator of trend. It takes up recent move and the past move into consideration for defining a trend. Therefore, erratic volatile price movements can be easily filtered and the real price action can easily be absorbed using simple moving average or the exponential moving average.
The three commonly used moving averages are- Simple Moving Average, Exponential Moving Average and Linear weighted moving average. The calculation of each is different and each has its own significance. Every trader uses MA in his own way to understand the different implications of price action.
Simple Moving Average (SMA)
The SMA is the arithmetic mean, i.e. it takes the sum of all closing prices over a specified period and divides the result by the same specified number. For example, a 20-day simple moving average takes the closing price of the last 20 days and divides it by 20.
The SMA assumes equal weightage to all the prices, i.e. It assumes equal weightage for the first day and twentieth day
The most commonly used Simple Moving average by traders are 20 SMA,50 SMA, 100 SMA and 200 SMA.
How to trade with the SMA?
Trading with moving averages especially with simple moving average is one of the easiest and widely used strategies. Traders can choose their favorite SMA and a timeframe of 1-hour or above. We have chosen 50 SMA on 1-hour time frame in NZD/JPY pair. As you can see, the simple moving average captures the trend move early. A long trade is initiated when two or more candles close above the 50-SMA. Likewise, a short trade is initiated when two or more candles close below the 50-SMA. Traders can either choose target based on their risk-reward profile or keep a trailing stop loss based on the opposite signal.
Moving average strategies can be cumbersome and sometimes even be suicidal in a sideways market. A simple way to identify the sideways market is with the slope. If the slope of the SMA is 20 degree or below, then the market can be identified as a sideways market. A trade with SMA should only be put through if the slope of the moving average is 20 degree. As you can see in the above chart, two signals have been filtered by the application of slope. Likewise, there can be instances when numerous trade opportunities will be missed because of this criteria but it is imperative to understand that most of those trades can be traps.
Linear Weighted Moving Average (WMA)
Linear Weighted Moving Average gives weightage to the price on the basis of its proximity to latest closing price. Hence, the closing price of the 20th day will be multiplied by 20, 19th day by 19 and first day by 1 and dividing it by the sum of the multipliers. It is the least commonly used.
Exponential Moving Average (EMA)
The EMA is also a weighted average. It gives higher weightage to the latest closing price and decreases the weightage exponentially as it moves down. For example, a 20 day EMA has a weightage of 12% and as it goes down, the first day EMA has only 0.5% weightage.
Thanks to the modern softwares. The system does all these calculations automatically and the user just needs to feed the required parameters.
The most commonly used EMAs are 8 EMA, 21 EMA and 55 EMA (Fibonacci numbers).
How to trade with EMA?
Just like the SMA, EMA can also be used to initiate trades. EMA is quick to respond than the SMA and so trend can be identified even quicker. Take a 21 EMA in 1-hour time. We have chosen the same NZD/JPY pair. As you can see, the 21-EMA has produced a lot of buy-sell signals in a short span of time than the SMA but the trades were short-lived. Hence, a trader needs to be proactive while using EMA. But, it is advisable not to use EMA as a single determinant for trade initiation. Indicators like RSI, MACD or stochastic can be used alongside EMA in order to produce accurate trades.
The commonly used Simple Moving Averages are 20, 50, 100 and 200.
The commonly used Exponential Moving Averages are 8, 21 and 55.
SMA is used alongside the slope in order to identify potential trend moves.
Combine EMA with indicators like RSI, MACD and stochastics for effectiveness.