Sep-11-2024
In this article you will learn:
The mean price and moving averages
If you are new to trading and wondering how a moving average works, it is quite simple thanks to our guide to moving averages. As the name would suggest, moving averages (MA) provide traders with a visual representation of an average for the price of an instrument, such as a forex pair, over a certain period of time.
Moving averages smooth out price action to reveal patterns we might otherwise miss on a vanilla price chart. Moving averages can suggest when markets are overbought and oversold relative to the average price of the asset or instrument we are looking to trade. Typically oversold zones offer traders the opportunity to buy (at a discount). Overbought zones offer an opportunity to sell (at a premium). For instance, if we see that Nifty is trading below its 50-day moving average on the daily chart, we can assume that this pair, as it is now, is in a bearish phase. If trading above the 50-day moving average, we could say it is still bullish.
Markets have a tendency to revert to the mean, or average, price. When we add moving averages to a chart, we see prices continually reverting to the mean (mean reversion). This is the market's way of equalizing buying and selling action to find the true value for the asset being traded. Every time the price moves away from the moving average, you’ll notice it travels only so far before reverting back to the moving average.
Different types of moving averages explained
All moving averages are lagging indicators, which means they don’t predict new trends, rather, they confirm market trends once they have been formed. They do not predict future price movements.
What are the three most common types of moving averages?
There are three common types of moving averages:
Simple Moving Average (SMA):
The Simple Moving Average (SMA) is the most basic type of moving average and reacts to price movement a little bit slower than the EMA.
Exponential Moving Average (EMA):
For intraday trading, traders may prefer to use the Exponential Moving Average (EMA) as it lags less than the SMA and is more responsive to recent price action over shorter periods of time. It is also better suited to breakout trades.
Volume Weighted Moving Average (VWMA):
The Volume Weighted Moving Average (VWMA) combines a measurement of price movement as influenced by tick volume. This indicator places more importance on movements in price owing to spikes or steep drops in tick volume. In a volatile market the VWMA will be quicker to pick up changes in volume and move more closely to price than the SMA. What this means in practical terms is that the WWMA alerts a trader to a potential breakout sooner than the SMA.
By adding the SMA and VWMA on the same chart and comparing the two, you can get a more accurate picture of price action. For example, if the VWMA is trailing below the SMA in a downward trend, we can infer that there is significant volume pushing price lower. The opposite could be inferred in an upward trend with the VWMA floating above the SMA. The VWMA will also alert you to a potential reversal a little sooner than a SMA, as you can see in the chart below where the VWMA is represented by the red line.
