This is the first of a two series post on Moving Averages. In this post, we introduce the notion of moving averages and then elaborate on how to compare their performance.

To begin with, Moving Averages (MAs) employ past price movements, usually the closing price, in order to smooth out any one-off erratic behaviour or unexpected/unexplained volatility (noise, as it also known) so that the user can see the trend more clearly. Put simply, a moving average simply averages the last values in a sequence of prices, depending on the length we choose. For example, a 9-period moving average would average the values of the last 9 periods, while a 20-period moving average would average the values of the last 20 periods.

The following table presents a short example of how a moving average works. The first box shows what the moving average value would have been at that specific point time. Notice that I am using a 5-period moving average in this example, which means that I am using the average of the last 5 prices of the currency pair (EURUSD in this case). Then, in the following box, we see that as another day elapsed, a new price came up (1.363), which pushed everything one position to the right. This means that the previous day’s price at rank #5 (1.382) has moved to rank number #6 and we will thus not use it in the calculation of the 5-period MA. This would mean that every period the price which was previously at number #5 will be scrapped, while a new price will enter at #1.

EURUSD

The analysis above is not limited to the 5-period case, but can be extended to any MA, from the fastest 3-period one to the longer-run 200-period MA. The difference between short- and long-term moving averages mainly lies in what we seek to study. As expected, the longer-term MAs tend to show us the longer-term trend, while short-term MAs allow for the examination of shorter-term movements in the price. Mathematically, this makes sense given that a new price in a 5-period moving average would receive a weight of 1/5, which is much bigger than 1/200 in the case of a 200-period moving average. A good example of short- and long-term moving averages can be seen in the first image of this post.

In particular, we see that the shorter-term MA (purple line), specified to have 20 periods, moves much faster than the longer-term MAs. As it appears, the 200-period MA (green line) and the 100-period MA (yellow line) tend to move much more slowly to changes in the price. The orange line, depicting the 50-period MA, moves in-between shorter and longer MAs. Naturally, other MAs also exist, with any possible number of periods being up for use.

To begin with, notice how using just long-term MAs would be pointless: the 200-period MA and the 100-period MA cross just once in 1-hour chart, with the cross not providing any meaningful sign as the two move more or less in parallel. In essence, what we would really like is for shorter-term MAs to cross longer-term MAs. For example, the 50-period MA, in combination with the 200-period MA issue much better signals in this chart. As the 50-period MA crosses the 200-period MA from below a sell sign is issued. The sign, in retrospect or backtesting if you prefer, appears to be correct, even though the sell sign issued later on does not work as expected. In particular, it appears that the sell sign would come too late, given that we would have already experienced losses at that point.

EURUSD

On the other hand, the 20-period moving average and the 50-period MA appear to work much better. As the picture suggests, the signals issued appear to be much more accurate, regarding the ongoing trend. Naturally, the signs do not provide support as to where the trading target should be, but we will leave that as a topic for a future post. Also note that the same MAs which offer good guidance for the 1-hour chart may prove problematic if employed at a different frequency.

EURUSD

The following chart illustrates the same two moving averages may not work so well for the 5-minute chart. The indicators, while correct for the larger movement in the middle of the chart, show too many false crossing signs which would lead to losses. This is most likely because the frequency is too high for the averages to reach proper levels. As such, one should remember that we need to backtest our moving average selection before committing ourselves to a trade. Thus, in the second part we will deal with shorter-term MAs and have a look as to how these can be used for other frequencies.

EURUSD

EURUSD

 

 

 

 

Disclaimer: Nothing in this communication contains, or should be considered as containing, an investment advice or an investment recommendation or a solicitation for the purpose of purchase or sale of any financial instrument.

Recommended Content


Recommended Content

Editors’ Picks

AUD/USD recovers above 0.6750 after Australian jobs data

AUD/USD recovers above 0.6750 after Australian jobs data

AUD/USD picks up a late bid and recovers above 0.6750 in Asian trading on Thursday, following the release of mixed Australian employment data. The extended post-Fed US Dollar recovery, amid a cautious market mood, could limit the pair's upside ahead of US data. 

AUD/USD News
USD.JPY jumps toward 144.00 on the road to recovery

USD.JPY jumps toward 144.00 on the road to recovery

USD/JPY gains traction and approaches 144.00 in Thursday's Asian session. The uptick of the pair is bolstered by the impressive US Dollar recovery. Investors shift their attention to the US data and the Bank of Japan interest rate decision on Friday. 

USD/JPY News
Gold price remains on the defensive amid the post-FOMC USD recovery from YTD low

Gold price remains on the defensive amid the post-FOMC USD recovery from YTD low

Gold price struggles to lure buyers despite the Fed’s jumbo interest rate cut on Wednesday. A further recovery in the US bond yields underpins the USD and caps the non-yielding metal. Concerns about an economic slowdown, along with geopolitical risks, help limit the downside.

Gold News
Ethereum attempts recovery following first rate cut in four years

Ethereum attempts recovery following first rate cut in four years

Ethereum is trading above $2,330 on Wednesday as the market is recovering following the Federal Reserve's decision to cut interest rates by 50 basis points. Meanwhile, Ethereum exchange-traded funds recorded $15.1 million in outflows.

Read more
Australian Unemployment Rate expected to hold steady at 4.2% in August

Australian Unemployment Rate expected to hold steady at 4.2% in August

The Australian Bureau of Statistics will release the monthly employment report at 1:30 GMT on Thursday. The country is expected to have added 25K new positions in August, while the Unemployment Rate is foreseen to remain steady at 4.2%.

Read more
Moneta Markets review 2024: All you need to know

Moneta Markets review 2024: All you need to know

VERIFIED In this review, the FXStreet team provides an independent and thorough analysis based on direct testing and real experiences with Moneta Markets – an excellent broker for novice to intermediate forex traders who want to broaden their knowledge base.

Read More

Majors

Cryptocurrencies

Signatures