Forex traders learn and then use all sorts of tools and techniques required in trading to expand their toolset and get a better understanding of the market. In order to smoothen out the market, the current prices, and to determine the possible direction of the market, a few common practices that are prevalent among forex traders are the use of different types of moving averages.
These are used to average out the instrument price for a particular time period. Each of these types has their own smoothness level and their moving average changes with the way prices are reflected and the way the market behaves due to these changes.
Normally, it has been noticed that the smoother the moving average, the more time it would take or the slower it is to react to the market price movements. Whereas, the rougher it is, the quicker it would react to the price movements that are currently taking place in the market. The various types of moving averages can either increase or decrease as per the changes in price.
Simple Moving Average (SMA)
Out of all the type of moving averages, this type is the simplest hence the name. It is also referred to as arithmetic moving average and is calculated by adding up the closing prices of a certain number of periods and then dividing this value by the number of periods whose closing price you have taken.
Its formula is as follows:
SMA = Sum of the closing prices of n periods/n
Where n = number of periods taken for calculation
One of the drawbacks of using this SMA is that it gets majorly affected by spikes in the chart pattern, which would give you an incorrect notion regarding the actual price movements.
Exponential Moving Average (EMA)
Exponential moving averages are considered to be more reliable than simple moving averages as they give more weight to the recent periods. It solves the problem that is faced when calculating SMA. It is calculated by adding a certain share of current closing price to yesterday’s exponential moving average. The formula is:
EMA = (current period close price * % of using price value) + [yesterday’s EMA value * (1 – % of using price value)]
Weighted Moving Average (WMA)
WMAs are more difficult to calculate and construct when compared with other types of moving averages. When calculating this average, more weight is given to the current data than the past ones. It is calculated by multiplying each of the closing prices that are taken into consideration for calculation, with its particular weight coefficient. The formula for WMA is as follows:
WMA = SUM (Current closing price * Smoothing period)/ Total sum of weight coefficients
We recommend you follow these common types of moving averages which are widely used by established forex traders to predict what new trend is forming or soon will form in the market.