theforexwriter’s Weblog

The concept of a simple moving average (SMA) is, well, simple: the more time periods used to calculate it, the less sensitive the results; the fewer used, the more sensitive.

An SMA calculated over one time period, to use a silly example, is the same as the price used to calculate it, and therefore the line graphed of such an MA(1) by your charting software atop your forex trading chart would follow in lockstep with that price.

One calculated over two time periods, an MA(2), would average those two prices and trace a line between them on the chart.

As the number of time periods used in the calculation continues to rise—three, four, ten, 100—the averaging process means that any single price has less effect on the SMA as a whole, thus lessening its overall sensitivity to sudden changes in trend. If a currency pair makes an abrupt dive or climb, it takes a while for a long-term SMA to catch up, which is why it’s categorized as a lagging indicator: it shows where the price has been.

An SMA calculated over a very large dataset—say, 200 time periods—has lost almost all of its sensitivity to sudden market fluctuations. Its most common use is as a long-term trend indicator, e.g., when the current price is above its MA(200) graph, it’s above the average of the previous 200 prices and therefore the trend is rising; if the current price is below the MA(200), the opposite is true.

On the other hand, an SMA calculated over a fairly small dataset—five time periods, for example—responds pretty quickly to changes in the market’s direction. Sometimes, though, it responds too quickly, not smoothing out enough of the market’s jitters and “background noise,” and giving technical traders false entry and exit signals, ruining what otherwise might have been a perfectly good day.

So if a small dataset creates an SMA that’s too sensitive, and a large dataset makes one that’s not sensitive enough, what’s a technical trader to do? Barbara Rockefeller, in her primer Technical Analysis for Dummies (2004, Wiley Publishing, Inc.), gives a good answer to that question. It’s called the moving average crossover.

Here’s the strategy:

Plot two moving averages atop your currency pair’s chart, one with a small dataset and one not quite so small. I personally like using an SMA(5) and an SMA(20), and for the rest of this blog entry I’ll use those two as my working example, but each trader should experiment to find the exact indicators that work for his or her favorite currency pair. (Remember that each currency pair has its own unique characteristics, and what works fabulously for one might fall flat on its face with another.)

When the SMA(5) crosses above the SMA(20), that’s a signal to enter the market long, and when it crosses below, that’s a short-selling signal. (Another thing to remember is that each trade should be based, not on one market signal, but on several. This strategy works better and generates fewer false entry and exit signals when combined with an oscillator such as the RSI or MACD, and we’ll cover those in future posts. But there’s no strategy on the planet that never generates a false signal, because in forex trading, there’s no such thing as always.)

Check out this chart:

This is the current one-hour chart of the U.S. dollar vs. the Mexican peso (USD/MXN), with the SMA(5) plotted in yellow and the SMA(20) in light blue. It’s obvious that this currency pair has strong trends and a lot of volatility (it moved almost 900 pips on June 10, lost almost half of that June 11 then regained it and more during the afternoon, and then lost almost all of its gains on June 12, man, what a ride) so it can be a good currency pair for this strategy. But again I emphasize, use additional indicators to confirm any signal before you enter the market. It’s also worth noting that, as a minor currency pair, this one generally has a reeealllly wide spread and a lot of pips to earn before you get a penny.

Anyways, when the yellow line crosses above the light blue line, that’s a buy signal, and the more “air” you can see between the two lines, the stronger the signal is. On June 10, when the market moved so dramatically, there’s enough room between the two SMAs to drive a Mack truck, and signals just don’t get any stronger than that.

This is one potential moving average strategy. It’s not patented by any means, so feel free to paper-trade with it and customize it to your own trading needs, experimenting with combinations of time periods and other technical indicators to find the fit that’s perfect for you and your favorite currency pair.

And happy trades to you.