TECHNICAL

Technical Analysis for Forex Traders

Introduction to Technical Analysis

Bollinger Bands... Relative Strength Index... Stochastic Oscillators... Fibonacci Retracements. If just hearing these terms fills you with trepidation, you're not alone. The good news however, is that despite their intimidating names, most technical indicators are really not that difficult to use, and it is possible for traders of any experience level to incorporate these indicators into their daily trade-decision process. In fact, with the latest generation of trading platforms fully capable of performing the necessary calculations for you, gone are the days when only mathematicians could generate accurate market charts.
In this series of lessons, you will find a no-nonsense approach to working with the most popular technical indicators. Each section includes an easy-to-understand overview of each indicator, together with relevant examples that demonstrate how to apply and interpret indicators to help you make informed decisions.
While this lesson does not require you to have any past experience with technical indicators, it does assume that you have some understanding of currency trading. If you need to brush up on your forex basics, you are encouraged to read the first book in this series

How to Use Moving Averages in Forex

Using moving averages to assess trend direction is the oldest form of technical analysis and remains one of the most commonly used indicators. The primary benefit provided by a moving average is to reduce market "noise" (rate fluctuations) that make it difficult to accurately interpret real-time exchange rate data. Moving averages "smooth out" these fluctuations, making it easier for you to identify and authenticate potential market rate trends from the normal up-and-down rate fluctuations common to all currency pairs.
All traders seek to find a trend when studying pricing data. Traders also attempt to identify a rate trend reversal point in order to time market buys and sells at the most profitable level. Moving averages can help in both regards.
Moving averages are essential to other types of technical analysis as well - most notably Bollinger Bands and Stochastic Measurements. You'll learn about these indicators in later lessons.

Advantages of Using Moving Averages

Overview

• Moving averages "smooth out" market rate fluctuations that often occur with each reporting period in a price chart.
• The more frequent the rate updates - that is, the more often the price chart displays an updated rate - the greater the potential for market noise.
• For traders dealing in a fast-moving market that is "ranging" or "whipsawing" up and down, the potential for false signals is a constant concern.

Comparison of 20-Period Moving Average to Real-Time Market Rates

The greater the degree of price volatility, the greater the chance that a "false" signal is generated. A false signal occurs when it appears that the current trend is about to reverse, but the next reporting period proves that what initially appeared to be a reversal was, in fact, a market fluctuation.

How the Number of Reporting Periods Affects the Moving Average

• The number of reporting periods included in the moving average calculation affects the moving average line as displayed in a price chart.
• The fewer the data points (i.e. reporting periods) included in the average, the closer the moving average stays to the spot rate, thereby reducing its value and offering little more insight into the overall trend than the price chart itself.
• On the other hand, a moving average that includes too many points evens out the price fluctuations to such a degree that you cannot detect a discernible rate trend.
• Either situation can make it difficult to recognize reversal points in sufficient time to take advantage of a rate trend reversal.

Candlestick Price Chart showing three different moving averages lines 

 

 

Types of Moving Averages

Overview

• There are several types of moving averages available to meet differing market analysis needs. The most commonly used by traders include the following:
  1. Simple Moving Average
     
  2. Weighted Moving Average
     
  3. Exponential Moving Average
     

Simple Moving Average (SMA)

• A simple moving average is the most basic type of moving average. It is calculated by taking a series of prices (or reporting periods), adding these prices together and then dividing the total by the number of data points.
• This formula determines the average of the prices and is calculated in a manner to adjust (or "move") in response to the most recent data used to calculate the average.
• For example, if you include only the most recent 15 exchange rates in the average calculation, the oldest rate is automatically dropped each time a new price becomes available.
• In effect, the average "moves" as each new price is included in the calculation and ensures that the average is based only on the last 15 prices.

With a little trial and error, you can determine a moving average that fits your trading strategy. A good starting point is a simple moving average based on the last 20 prices.

Weighted Moving Average (WMA)

• A weighted moving average is calculated in the same manner as a simple moving average, but uses values that are linearly weighted to ensure that the most recent rates have a greater impact on the average.
• This means that the oldest rate included in the calculation receives a weighting of 1; the next oldest value receives a weighting of 2; and the next oldest value receives a weighting of 3, all the way up to the most recent rate.
• Some traders find this method more relevant for trend determination especially in a fast-moving market.

The downside to using a weighted moving average is that the resulting average line may be "choppier" than a simple moving average. This could make it more difficult to discern a market trend from a fluctuation. For this reason, some traders prefer to place both a simple moving average and a weighted moving average on the same price chart.

Candlestick Price Chart with Simple Moving Average and Weighted Moving Average

Exponential Moving Average (EMA)

• An exponential moving average is similar to a simple moving average, but whereas a simple moving average removes the oldest prices as new prices become available, an exponential moving average calculates the average of all historical ranges, starting at the point you specify.
• For instance, when you add a new exponential moving average overlay to a price chart, you assign the number of reporting periods to include in the calculation. Let's assume you specify for the last 10 prices to be included.
• This first calculation will be exactly the same as a simple moving average also based on 10 reporting periods, but when the next price becomes available, the new calculation will retain the original 10 prices, plus the new price, to arrive at the average.
• This means there are now 11 reporting periods in the exponential moving average calculation while the simple moving average will always be based on just the most recent 10 rates.

Deciding on Which Moving Average to Use

• To determine which moving average is best for you, you must first understand your needs.
• If your main objective is to reduce the noise of consistently fluctuating prices in order to determine an overall market direction, then a simple moving average of the last 20 or so rates may provide the level of detail you require.
• If you want your moving average to place more emphasis on the latest rates, a weighted average is more appropriate.
• Keep in mind however, that because weighted moving averages are affected more by the latest prices, the shape of the average line could be distorted potentially resulting in the generation of false signals.
• When working with weighted moving averages, you must be prepared for a greater degree of volatility.