Moving averages remain one of the most commonly-used tools for carrying out technical analysis in Forex trading. Generally, moving averages are lines plotted on charts to give the average price in a given point over a definite period of time like minutes, hours, days, or weeks.
Along with other tools, they assist Forex traders to forecast potential price movements in the market before making trading decisions. A major limitation of moving averages is that they lag price; that is, if price starts to change trend, the new data will not be reflected into the moving average computation immediately. To address this weakness, it is important to use moving averages with shorter time period. For example, 5 or 10 day moving average would be more helpful than the 60 or 175 day moving averages.
Moving averages identify potential trading opportunities through their interactions with the prices of the currencies or with one another. Normally, if you plot one moving average on your chart, an opportunity to buy will emerge when the price closes above the average. On the other hand, an opportunity to sell will emerge when the price closes below the average. Just like any other strategy for Forex trading, moving averages should be combined with other strategies for better results to be realized.
There are many types of moving averages, and the three most common ones are simple moving averages, exponential moving averages, and weighted moving averages. A simple moving average is the simplest type of moving averages, and it is calculated by adding up a currency’s closing prices for some period of time and dividing by the amount of these periods. For example, if you want to plot a 6 period simple moving average on 10-minute chart, you would add up the closing prices of the last 60 minutes and then divide that number by 6, and in this way, you will have the average closing price over the last sixty minutes.
In as much as they are simple to use, simple moving averages are very susceptible to spikes; thus, they can give wrong data. Exponential moving averages give more emphasis to the most recent periods (increases exponentially); thus, they are better for indicating the current situation in the market. When engaging in Forex trading, it is essential to know what is taking place in the market right now instead of knowing what took place in the previous days or weeks.