Moving Averages (MAs) are the oldest and simplest indicators in trading. In times when there were no computers, the easiest way to visualize price movement was to plot it on a chart. Computers turned moving averages into a powerful tool for technical analysis that is used in many different trading systems.
There are many types, but the best known are the simple moving average (SMA), the exponential (EMA) and the weighted average (WMA). SMA is just an average of price over a certain period of time. EMA and WMA tend to give more weight to recent price, so they are more sensitive to rapid price movements.
MA Based Trading Signals
Moving averages filter out small swings from the price movement giving the main direction of the trend. If it points up, it means the trend is up. If it points down, it means the trend is down. In that sense, the moving average is a trend indicator.
The main rule of trading with a moving average is to look for the price to cross it. If the price crosses below, it is the signal to sell the currency pair. If the price crosses above it is the signal to buy the pair. The averaging period plays an important role in generating trading signals. If the period is small, it will give a large number of signals, most of them will be false. But if the number of periods is too high, the moving average will lag too far and give signals too late.
The simplest trading strategy based on MA
Let us consider an example of the simplest trading system.
Enter Long when price crosses above MA(n)
Exit long when price crosses below MA(n)
Enter short when price crosses below MA(n)
Exit short when price crosses above MA(n)
n is a parameter that must be adjusted for a system to be profitable. It can usually be found in backtesting.
More complex trading system
In the market, when the trend changes frequently, going through consolidation phases, the trading system based on a moving average may not give very satisfactory results. You need to use some kind of filters. But the moving average itself is a good filter.
The trick is to use two different averaging periods. The shorter period curve will change faster with the price, while the longer period curve will be slower and will filter out false price crossovers. Signals will be based on crossovers of those curves, not price. So the simple system of two moving averages will look like this.
Enter Long when MA(m) crosses over MA(n)
Long exit when MA(n) crosses above MA(m)
Enter Short when MA(n) crosses below MA(m)
Exit short when MA(m) crosses below MA(n). where M