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Trading uncovered: What you need to know about moving averages

by , 03 February 2014

You have probably come across the term ‘moving averages'. Moving averages are a very popular technical indicator. But how do they work? And what do they show? Read on to uncover a quick introduction into moving averages…

A moving average indicator takes the average of a specified number of periods up to and including the most current period, Max Munroe in Forex Round-Up explains...

That period could be minutes, hours, days or whichever timeframe you’re looking at on your charts.

Let’s say you’re looking at a daily chart. You get today's closing price as well as the closing prices for the previous 19 days.

If you average these numbers by taking the arithmetic average, that will give you the value for today's moving average.

The difference between simple and exponential moving averages

This is an example of a simple moving average (SMA). This means the weights of each price are equal. So each price level has an equal impact on the value of the moving average.

But there is also the exponential moving average (EMA). This one weights the recent price levels more heavily than older price levels.

Take a look at the chart below. It shows the British pound versus Japanese yen (GBP/JPY) exchange rate. The EMA is in blue and the SMA in yellow.

See how the EMA moves closer with the current price trend than the SMA. This is due to the EMA's heavier weights on recent prices.

Both indicators are, however, lagging indicators since they 'follow' the price action. That means you should use them as confirmation signals.

One of the most popular SMAs is the 200-day SMA. Many traders follow this. These traders consider the trend given by the movement of this moving average as the long-term trend of the asset in question.

This indicator is one well worth looking at.

So there you have it, a quick introduction into moving averages.

Trading uncovered: What you need to know about moving averages
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