A moving average is a technical indicator that supports smooth out price action by filtering out the noise from casual short term price variation. Because of its simplicity, the moving average is extremely common among forex traders. It is a lagging indicator because it created on past prices. The most shared application of moving average is to define support and resistance levels and to find the trend direction. Moving average also forms the foundation of other technical indicators such as MACD (Moving Average Convergence Divergence).
There is a variety of moving averages to choose from but commonly used are simple moving average, exponential moving average and weighted moving average. The simplest type is a simple moving average which is calculated by taking the prices in a situation of financial instruments are added together and then divided by the number of cost in the set. For example, if you are calculating a simple moving average for 20 days, then you have to take values of past twenty days and divide the result by 20.
The exponential moving average gives more significance to the current price to make data more receptive to new information. At the same time, the weighted moving average put more importance on current data than the exponential moving average. Forex traders don’t have to calculate the values of all moving averages because many forex trading platforms do the calculation automatically for you.
The types of moving average are used to identify buy and sell signals in forex trading. Use of single moving average sometimes generate a false single; the only way to eliminate false signals is to use multiple moving averages all together. Let suppose you apply three moving averages, ten days, 20 days and 30 days average. If the ten-day average is above 20 days, and the 20-day average is above 30 days, it indicates an upward trend. At the same time, a downtrend is displayed when the ten-day line is below the 20-day average, and the 20-day average is below the 30-day average.
The moving average is considered one of the best technical indicators to identify price trend, but still, it has some limitations. It only works in a situation when the price is trending; it does not work when the price fluctuates in sideways or in range. So relying alone on moving average is much risky for any forex traders. The best way is to use a moving average in conjunction with other technical indicators.