This article will give you an understanding what moving averages are and how to best use them. Familiarity will all types of moving averages, especially the exponential moving average, should greatly improve your ability to trade Forex.
To begin, let us debunk a myth that gets circulated amongst new traders. Many believe that there is some type of “magical moving average” that the banks follow. They believe that somewhere there is a moving average that “cannot miss.” Nothing could be further from the truth, as much like anything else, a moving average is simply a tool which traders can use to define a trend, and perhaps find potential areas of support and resistance. The key word here of course is “potential.”
What is an “EMA” in Forex Trading?
“EMA” stands for Exponential Moving Average. To understand what it actually is, you need to understand what a simple moving average is. The moving average is a plotting of the average price over the last defined number of candlesticks. In other words, it is the average price over the previous 20 candles, 50 candles, 100 candles, or whatever. The trader can select how many candles they want to look back at. While moving averages can use the open, high, low, or close price of the candlestick, 99.9% of the time you will see people use them applied to the closing prices of these candlesticks.
The simple moving average (SMA) is the straightforward moving average calculation that you would expect. In other words, if the 20 SMA is plotted on the chart, it will let you know what the average price was at the closes of the previous 20 candlesticks. As the market advances to generate another candlestick, it will simply adjust the calculation to include only the immediately previous 20 candlesticks, and so on. By taking the average closing prices and adding them, then dividing by 20, the SMA comes up with its calculated value. It then plots the calculation on the chart, drawing a line through all of the dots to form a longer line across the width of the chart.
The EMA in Forex trading is the same thing, except the formula is mathematically weighted to put more emphasis on the most recent candlesticks. This causes this type of moving average to be more immediately sensitive to price fluctuations and therefore it will change direction more quickly. Which type of moving average in Forex trading should you use? Most traders use the EMA, but at the end of the day they are used in mostly the same way. Take a look at the chart below and notice the slight difference between the two. The black line is a 20-day Simple Moving Average, while the red is a 20-day Exponential Moving Average.
How the EMA is Usually Used in Forex Trading
There are a multitude of uses for the EMA in Forex online trading, and quite frankly your imagination is the only limit.
EMA as a Measurement of Trend
In its most basic form though, traders tend to use the EMA as a measurement of trend. In other words, if the moving average is rising over time, then it is assumed that the trend is also very positive. Conversely, if a moving average is drifting lower over time, then the market is thought of as being bearish or negative.
EMA as Dynamic Support/Resistance
Some traders will use specific EMAs as dynamic support and resistance. This is because there are some very widely followed Exponential Moving Averages. Most of them harken back to the days of stock trading. Some of the most common ones are the 20-day EMA, 50-day EMA, 100-day EMA, and the 200-day EMA. This practice of using these particular round numbers is psychological and goes back to the early years of technical analysis, and therefore it is more or less a convention that anything else. As you continue your online trading career, you will see moving averages that people insist perform better than others, but at the end of the day it is a personal preference issue. Shorter-term traders tend to like smaller numbers such as the 9 EMA, because it is so quick to react in comparison to something like the 50 EMA. However, if you are a longer-term trend trader, then you pay much more attention to higher numbers because it takes much more information and movement to change the direction of those moving averages, thereby keeping you in the trade for much longer periods of time. To see dynamic support and resistance in action, take a look at the chart below:
Multiple EMAs as a “Dragon”
As you can see in the price chart below, there are multiple EMAs plotted, and you can see just how differently each one reacts to price on the daily chart. In this chart I have plotted the 9, 20, 50, 100, and 200-day EMAs. In fact, some people use this exact type of set up to make sure that they are trading with a multitude of traders as far as the trend is concerned. They will only trade in the direction all moving averages and only when they are all moving in the same manner.
EMA Crossover System
Another way that people will use the EMA as an indicator is in a “crossover system” as a trading strategy. This is one of the most basic online trading systems out there, and by its very nature needs a trend in order to be profitable. This is done by using two moving averages, one as a short-term moving average and one as a longer-term moving average. In the example in the price chart of the CAD/JPY currency cross shown below, I have the 50-day EMA plotted in red, and the 200-day EMA plotted in black. The idea is that if the shorter moving average, in this case the 50-day EMA, crosses above the 200-day EMA, you should be looking to take long trades. Conversely, if the 50-day EMA crosses below the 200-day EMA, you should be looking to take short trades. Some traders use this as a mechanical system to simply generate trades with no filter whenever the crossover happens. The biggest problem with this of course is that you need a strong trend for it to work, and in a ranging market you will get a lot of whipsaw trading, causing repeated small losses, but eventually you get a strong trend and you make larger profits. It takes a certain type of psychology to be able to trade this system over the long term.
The Exponential Moving Average is one of the most common and basic technical indicators that you can use. However, it is not a “silver bullet” for profit. It is just a tool like any other indicator, and you should be very skeptical of anybody who tells you that “this is the moving average the banks use”, because there is no magic formula. Moving averages can give you an idea as to which direction the trend is moving, and also can give you an idea of where some traders may be looking to buy or sell, but you still need to use the price action to make your trading decisions, as all indicators are secondary to the big picture. You use them to confirm price action not to replace it. The example shown in the price chart below is of a breakout that is confirmed by the 20 EMA.
Exponential Moving Averages FAQs
How do you use the EMA in Forex?
You can use the exponential moving average (EMA) multiple ways in the Forex market. The most common way is to use those moving averages to define the trend, but it is also worth noting that there is no “perfect moving average”, although some will try to tell you otherwise. There are also moving average crossover systems, and of course dynamic support and resistance.
What does EMA mean in Forex?
EMA stands for Exponential Moving Average, which is different than a typical moving average, as it factors in the most recent price action with a little bit more weight in its formula, making it more responsive to price changes, thereby catching shifts in the trend much quicker than a simple average does.
What is the best moving average to use in Forex?
Unfortunately, there is no “best” moving average to use in Forex trading. However, it is worth noting that there are some very commonly used ones, such as the 9, 20, 50, 100, and 200 exponential moving averages (EMAs). There are various systems out there that may use more “exotic” moving averages, but at the end of the day they all tend to produce the same results.
What is the 50 EMA?
The 50 EMA is simply the exponential moving average of the last 50 periods. The timeframe does not matter, it is just the moving average of the last 50 candlestick’s prices, normally based upon the closing price. It is represented by a squiggly line on the chart that you can use to figure out what the average price was over the previous 50 candlesticks. It goes up in an uptrend, and down in a downtrend.