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The moving average (SMA) and the Exponential Moving Average (EMA)

The simple moving average is one of the most popular and simplest forex indicators. It is the average price of the base currency over a certain period of time. Lets say we have 60 closing prices for the last 60 days. Then you sum up the price and divide the result by 60. Equal weighting is given to each daily price.

In order to design your forex trading strategy, you may also consider a smaller window, say 20 days and slide this window within the interval of 60 days. In this case you obtain 40 values of SMA corresponding to the 20 day window. The window will smooth small and unimportant oscillation and these 40 values may  give you an idea of where the market moves. Many traders watch for short-term averages to cross above longer-term averages to indicate the beginning of an uptrend.

The short-term averages (for instance 20 day SMA) act as levels of support when the price experiences a pullback. Support levels become stronger and more significant as the number of time periods used in the calculations increases.

Exponential Moving Average(EMA)

It is true that the data gets “smoothed” by SMA. However, if the window is too small,  a sharp short variation of the data (spike) may generate a result which is hard to interpret

Consider an SMA using for a particular currency pair and the closing prices for the last 5 days are listed below:

  • 1.4533
  • 1.4533
  • 1.4533
  • 1.4533
  • 1.4533---------------------------------  5  day window
  • 1.4500 spike
  • 1.4520
  • 1.4543
  • 1.4550---------------------------------

We may omit the first three digits 1.45 and consider the following series

  • 33----------------------------------------
  • 0  spike
  • 20
  • 43
  • 50-----------------------------------------

The SMA  is  33+0+20+43+50 divided by 5 equals to 29.2. If you compare it with the previous stable value 33 it looks like the price is either stable or goes down whereas in fact it goes up.

Exponential Moving Average indicator  assigns weights to the prices. In statistics they say that these weights “increase exponentially”. What it actually means that  the latest prices get more weights. So  that the present and the nearest past become more important than a distant past.

For instance, the weights could be assigned as follows

  • Price     weight
  • 33          0.05   past
  • 0            0.05
  • 20          0.1
  • 43          0.3     near past
  • 50          0.5     present

In this case

33 0.05+0.05+20 0.1+43 0.3+50 0.5= 41.55 which exceeds the previous trend 33.

There are many variations of the exponential moving average. Many of these variations base their calculations on the volatility of the market.