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One of the earliest technical indicator is the moving average. By definition it is a very simple calculation of a price over a certain period of time, but its applications are numerous and can get pretty sophisticated. Here we will explore the different ways the moving average are used in analyzing the charts of a financial market. This article is meant to highlight how a simple indicator can be used, from providing trading signals, filtering out trades, and even creating other technical indicators.
Example of EUR/AUD with 200, 100, 55, 21, and 8 simple moving averages in the 4H chart:
Assuming you know the basic definition of the moving average, I won’t get into that. I will also use the simple moving average (SMA), unless specified. Discussion of different types of moving averages will be reserved for a different time.
1) As an indicator of general trend relative to price:
- Where price is trading relative to the moving average is one indication of the direction of the market. Above the MA, price is said to be bullish, and vice versa. If the price is moving up and down across the MA, the market is said to be ranging.
- The slope of the moving average also gives you the indication of a trend. Therefore price trading above an upward sloping SMA reflects a market that is more bullish, than price trading above a downward sloping moving average.
- The smaller the moving average, the more it “hugs” price action, therefore it is indicative of direction relative to recent price action. The larger the period used in calculating the moving average, the more historic price action is calculated, thus reflecting direction of the market relative to a longer time span.
- Some common moving average periods (which I use) are 5, 8, 21, 55, 100, 200.
Here is a chart of the GBP/USD in the 4H time-frame from mid February to mid March. Notice the market “whipping” the 100SMA up and down. Also the slope of the 100 SMA is pretty much flat, reflecting a range-bound or non-trending market. In this GBP/USD chart, we also see an RSI reading at the bottom of the chart, which whips between 30 and 70, also reflecting a range-bound market
Following a Trend
This second chart shows EUR/GBP 4H chart showing price action from March through much of May. We see a downtrend and the price mostly respecting the 100-SMA as resistance. Meanwhile, the RSI was held below 60 and was tagging 30. However, when the price crossed back above the 100-SMA, and the RSI was able to push to 70, the downtrend was challenged.