One of the earliest technical indicator is the moving average. By definition it is a very simple calculation of a price over a certain period of time, but its applications are numerous and can get pretty sophisticated. Here we will explore the different ways the moving average are used in analyzing the charts of a financial market. This article is meant to highlight how a simple indicator can be used, from providing trading signals, filtering out trades, and even creating other technical indicators.

Assuming you know the basic definition of the moving average, I won’t get into that. I will also use the simple moving average (SMA), unless specified. Discussion of different types of moving averages will be reserved for a different time.

1) As an indicator of general trend relative to price:

- Where price is trading relative to the moving average is one indication of the direction of the market. Above the MA, price is said to be bullish, and vice versa. If the price is moving up and down across the MA, the market is said to be ranging.

- The slope of the moving average also gives you the indication of a trend. Therefore price trading above an upward sloping SMA reflects a market that is more bullish, than price trading above a downward sloping moving average.

- The smaller the moving average, the more it “hugs” price action, therefore it is indicative of direction relative to recent price action. The larger the period used in calculating the moving average, the more historic price action is calculated, thus reflecting direction of the market relative to a longer time span.

- Some common Moving averages are 5, 8, 21, 55, 100, 200.

Here is a chart of the EUR/AUD daily chart taken on 11/29/2011. Notice the market “whipping” the 100SMA up and down. Also the slope of the 100 SMA is pretty much flat, reflecting a range-bound market:
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This second chart shows USD/CHF 4H chart taken also on 11/29/2011. It has been respecting the 55 SMA since crossing above it in the beginning of November. As the slope flattens toward the end of November, the market is beginning to test the resolve of this support:
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2) As an indicator of general trend based on orientation of 2 different moving averages:

- Moving averages of different lengths represent a general price of different degree. For example, the 21-SMA respresents short-term mean price action versus the 200-SMA, which represents a long-term mean price action.

- A crossover between a short to a longer term moving average (ie. 21 SMA crossing 55 SMA) reflects a change in trend. Meanwhile,  if the 21-SMA is spreading further away from the 55-SMA, it is a confirmation of strength in the trend.

Here is an example of the EUR/USD daily chart taken 11/29. Red is 100SMA, Blue/Violet is 55SMA: Note the crossover reflecting the change in trend of the market, but also note that this crossover happens after the market already made the turn:
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Because of the lag, if the market is not trend and choppy, the signals will be too late and false. Here is an example of the EUR/GBP with a couple of late and false signals, before a late but signal that still was followed through:
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3) Other Multiple moving average systems:

Analytical and trading signals can be created with more moving averages as well.

- 3 moving average system: With an additional MA we can generate entry signals different from exit signals. This attempts to deal with the usual lag that 2 MA crossover systems have. The idea is to enter when medium length MA crosses longer term MA. Exit is provided when short-term MA crosses the medium one.
Here is an old example I dug up representing the 3-MA crossover using 4, 9, and 18 SMAs:
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The quicker exit helps a bit to a limit, and sometimes will exit too early if there is a deep correction before the trend gets going:
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- 4 moving average system: Another additional MA is added for the purpose to filtering out signals so as to only provide those in the direction of the trend.
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As you might already have figured out, this 4MA crossover system simply adds a filter to 2MA crossover. This means you can use 5MA system, where 2 MAs filter signals for the 3MA crossover system. The combination of things you can do with crossovers and filters grow as you add MAs, but I wouldn’t go too crazy with it because it can become overwhelming.

- Moving average congestion breakout signals: Another use of MA is to use multiple MAs to look for congestion. Since MAs represent price action of different degree, convergence of MAs suggest a loss of direction. This is usually accompanied by sideways price action. Then when the market decides on a direction, and price action starts to “pop” out from the moving averages, we have a breakout signal. Note that the breakout is only an entry signal.

In this example, the GBP/CHF is in congestion after a rally. A congestion is seen as price action forming a triangle. It was a twisting turning congestion that had many possible support drawn, but very apparent resistance. There is 1 if not many possible false breakouts to the downside and the market starts to run lower from the different moving averages as well as break projected support levels. However, a very strong bullish attempt to the upside cleared up that the market is in a bullish continuation.
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Analysts have developed many indicators that are derived from the moving average. Let’s take a look at a few of them. I won’t get into the details of each indicator as they deserve their own separate piece. We will see how they are constructed using the moving average.

4) MACD:

Short for Moving Average Convergence/Divergence. This indicator is constructed by using a 12 and 26 exponential moving average and calculating the difference. This creates the MACD line. A 9 period simple moving average of this MACD line is plotted as the signal line. The difference between the MACD and the signal line is plotted as a histogram.

This creates a centered oscillator. There are 3 basic signals generated by the MACD oscillator:
First, when the MACD line is above 0, it means 12EMA is above 26EMA, and the market is seen to be bullish. When MACD line is below 0, the 12 EMA is below 26EMA, and the market is considered bearish.
1) The crossover: When there is a crossover of the signal line and MACD D, a change of direction is indicated (The MACD-signal line crossover is an attempt to lessen the lag that the moving average crossover would have).
2)Divergence: When lower price is followed by higher low in MACD, there is a warning that the bear trend might be stalling, or coming to an end. On the other hand, when higher price is corresponded by lower MACD high, the uptrend might be slowing, or reversing.
3) Overbought/Oversold: You can look at historical highs and lows in MACD line and determine where the OB/OS levels are to give you counter-trend warnings. These are simple warnings, and shouldn’t always be taken as signals.

Here is an example of the MACD plotted on the AUD/USD 1H chart as of 11/29.
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5) MA envelop and Bollinger Band:

If you consider the MA as the mean price action of a certain period, then that means a range-bound market should revert back toward it. Thus the farther away from the MA, the more likely a trend will end. The bollinger band is designed to measure where the market might be too far from the moving average.

Traditionally the bollinger band plots the 20-day moving average and a band 2 standard deviations above and 2 std deviations below. This was done for stocks and the fact there is about 20 trading days in a month. Now there is a bit of a jump in concept here in that 2 standard deviations is support to contain 95% of values of a normal or Gaussian distribution (or one that fits the bell curve). This reflects natural distribution of height, weight, IQ, among other things. The distribution of price action is not necessarily such.

However, this does not mean the Bollinger band is useless, it just shouldn’t be used as a single indicator to go against a trend. I personally use 200SMA instead of 20, and put 3 standard deviations to catch markets that would be significantly more extreme (far from the MA), than would be shown by the conventional parameters.

Here is a cherry picked example of the EUR/USD 4H chart where the market tagged the upper Bollinger Band before falling back toward the 200SMA where it consolidated for a couple of weeks before falling lower, now nearing the lower bollinger band.
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Tip: The fact that the 200SMA was flat and not sloping builds a case for a range-bound market, where counter trend trading is most effective.

6) Horizontal shift; in Ichimoku Charts:

Moving the MA forward, it can act as a guide for future support or resistance. The Ichimoku Kinko Hyo hereon called simply Ichimoku) indicator/system manipulates moving average to give us visual cues of support and resistance as well as generate trading signals. However, instead of using the moving average of the closing price, it uses the MA of something different. Refer to the calculation below copied over from the FXTimes glossary.

Calculation

The Ichimoku chart consists of five lines constructed using only the midpoints of previous highs and lows. The five lines are calculated as follows:

1) Tenkan-Sen = Conversion Line = (Highest High + Lowest Low) / 2, for the past 9 periods

2) Kijun-Sen = Base Line = (Highest High + Lowest Low) / 2, for the past 26 periods

3) Chikou Span = Lagging Span = Today’s closing price plotted 26 periods behind

4) Senkou Span A = Leading Span A = (Tenkan-Sen + Kijun-Sen) / 2, plotted 26 periods ahead

5) Senkou Span B = Leading Span B = (Highest High + Lowest Low) / 2, for the past 52 periods, plotted 26 periods ahead

Kumo = Cloud = area between Senkou Span A and B

Here is an example of what the Ichimoku Kinko Hyo

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7) “Smoothing Out” other Indicators ie. Stochastic Oscillator:

The construction of the Ichimoku shows that we don’t have to use the MA of the close price. In fact if you think about what the moving average really is, it is simply a look at a series of data and smooths them out. Therefore, another use of the MA is to smooth out not only price data, but indicator data. For example, the stochastic oscillator uses a smoothing out process in its calculation:

Here is the formula as well as an image of the stochastic oscillator copied over from the FXTimes glossary:

When plotted on a chart, the indicator is usually plotted as 2 lines: %K and %D. %K is the main (fast) line and %D is the signal (slow) line.

A component of the stochastic formula is as follows:

Fast %K = ((Today’s Close – Lowest Low in %K Periods) / (Highest High in %K Periods – Lowest Low in %K Periods)) * 100
%D = 3-period simple moving average of Fast %K (This basically smooths out the Fast%K line)

The Stochastic Oscillator is calculated by the formula:

Fast %K = ((Today’s Close – Lowest Low in %K Periods) / (Highest High in %K Periods – Lowest Low in %K Periods)) * 100
Slowing %K = N-period moving average of Fast %K
%D = N-period simple moving average of Slowing %K

You can see in the example that the “full” stochastic has a smoother, rounder path, while the “fast” stochastic has a more jagged one.

Tip: technical indicators are all derived from price action. So the more you “smooth out” the indicator, the further it reflects price.

Fan Yang CMT is the Chief Technical Strategist FXTimes – provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.