The Moving Average By Rob Booker 2004 W. R. Booker II. All rights reserved forever and ever. And ever. The information contained in this ebook is designed to teach you methods of watching forex quotes so that you can make money. Alas, you ll probably lose money. We all do at first. Rob s not liable if, based upon the information you read here, you lose money, make money, turn into a woodchuck, possum, or other furry creature.
The Moving Average page 2 The Moving Average. Charting a moving average is a way to smooth price action over time. In short, you forecast future prices by charting the trajectory of prices over the past X number of time periods. Here are the basics: 1. A simple moving average is calculated by adding up the last X period s closing prices and then dividing that number by X. For a 5 period moving average on the EUR/USD 1hr chart, you would add up the closing price for the last 5 hours, divide that by 5, and you would have your 5 period MA. 2. If you re looking at the 1 hr chart, the moving average is the average of prices over a span of hours. If you re looking at the 5
The Moving Average page 3 minute chart, the moving average is the average of prices over a set of 5 minute periods. Just remember that the moving average corresponds to the time frame on the chart you are looking at. 3. An exponential, weighted, or exponentially smoothed moving average gives more weight to the most recent prices. There are many types of moving averages, but I concentrate on the Exponential Moving Average, as I feel that it rightly gives more importance to what has happened most recently. 4. Although moving averages smooth price action it is important to note that like every other tool, they operate on a delay. You are seeing an average of past prices (duh), so all you end up with is a forecast of future movement, not a rock-solid view of the future. How does a moving average smooth price? Well, let s say you re looking at a recent chart for the GBP/USD (above) and the price has taken a significant jump over the past few hours. If you look at the red line above, that s the 5-period moving average. The yellow line is the 30-period moving average. The blue line is the 62-period moving average. Instead of
The Moving Average page 4 only seeing the jump in price, now, you see what the average price is over the past 5 hours, the past 30 hours, and the past 62 hours., not just what the price is right now. And that s important, because how in the world could just one price a single view of how traders felt at one particular time tell you what overall market sentiment is? Remember, if you plot moving averages on a hourly chart, you re looking at hourly moving averages. If you re looking at a daily chart, the moving averages are daily. If you re a long term position trader, then you need to concentrate on checking the daily and weekly moving averages. If you re a short term trader, you will want to focus on the 10-minute, 30- minute, and hourly charts. Use the shorter term charts to time your entry for a longer trade. If you trade hour to hour, you might use the 10-minute chart to find a good entry point. If you hold positions longer than a few days, use the hourly charts (and moving averages) to calculate entry points. One simple way to make money is to chart a long term moving average against a short term moving average. The Simple Moving Average The value of a simple moving average (SMA) includes at least two elements. First, the length of the moving average itself, and the prices at each time period in the average. For instance, if you want to chart the 5- day SMA for the USD/JPY, you would first find the closing price of this pair for the past 5 days. Then you would add those prices together, and divide by 5. Day 1 Day 2 Day 3 Day 4 Day 5 110.10 109.90 109.50 110.25 110.75 These 5 closing prices, added together, equal 550.50. Divided by 5 equals 110.10. The good thing about the SMA is that it s, well, simple. You re going to have to find if you prefer it above other types but I prefer the Exponential Moving Average. The Exponential Moving Average The problem I see with SMAs are that they are susceptible to spikes. In the above 5-day example, what if day 3 was 107.00? That would skew the entire moving average and give you the impression that the pair was heading lower, when in fact that price was just an anomaly. An Exponential Moving Average (EMA) gives more weight to recent prices.
The Moving Average page 5 This is important because, as you can imagine, what traders are doing now is more important than what they did last week or last month. What to do with Moving Averages When moving averages are climbing upwards, the market is trending bullish I m not sure if I really believe in trends on the 5 or 10 minute charts (or at least I don t lend much credibility to them). But I do pay attention to the moving averages on the 15, 30, and the 60-minute charts. And, of course, on the daily charts. When moving average lines are sloping downward, the market is trending bearish. But moving averages aren t powerful because of that (you could see that from a series of lower or higher candles). Moving averages are good for choosing entry and exit points on your trades. For example, if you look at the chart below, we see the 5 EMA plotted on the 1 hour USDJPY chart. It just goes up and down, up and down. We could have seen that from just the candles.
The Moving Average page 6 But where were the good exit and entry points on trades? Look at the chart below, which adds just the 30 EMA in yellow: What we learn from this chart: 1. When the red line crosses below the yellow line, sell. When the red line crosses above the yellow line, buy. If you simply did exactly that each time on this chart, you would have made 10 pips on every trade. And that brings up a good point what s the exit point for a EMA crossover trade? The best exit is a profitable exit My first point of exit is always 10 pips. If I get 10 pips a day, I m going to make a lot of money over the long term. You probably already knew that I was going to say that. An alternate point of exit is another crossover. There are plenty of ways to do this, but the basic point is this:
The Moving Average page 7 To exit the trade, use a shorter EMA crossover than you used to enter the trade. Here s an idea: exit the trade when the 3 (below in green) crosses back below the 5 EMA (in red). Last of all, a warning: EMA crossovers are profitable. There s no doubt about it. But it makes sense to trade them for 10 pips when you re using the short time frame charts. If you can get 10, be happy. There is always the chance to increase your limit to try for more, and I m not opposed to that. But if you get 10, and you get out, and you see the market move another 100 pips in the same direction, try to be happy with what you ve got. Don t let what you didn t get spoil what you did get. As you can see in the example above, the 5 EMA (red) crosses below the 30 EMA (yellow) at the right edge of the chart, and then shoots right back up. Sometimes crossovers don t work for very much profit.
The Moving Average page 8 Adding another EMA band will help. See the chart below, with the 5, 30, and 62 EMAs: Notice that although the 5 (red) crosses below the 30 (yellow) at that far edge, neither crosses the 62. This is a good indication that you might want to avoid the trade, and wait until the 62 is breached in either direction. To sum it up, it s going to take time for you to discover which averages work best for you. Try a bunch of different combinations. Chart them. If your charting software allows you to backtest (something I highly recommend), then back test your results. If you can t backtest your results, simply demo trade on the signals as much as you can. Take some time today and look back over your charts; using moving averages, try to find some good trades.