Lesson #29 Plotting the Moving Average

Comparison of Two Moving Average

A good tool to use is simple moving average. However, there is a big flaw related with it. Simple moving average will always be prone to market spikes. Here is a concrete example of its susceptibility:

On a EUR/USD daily chart, you can plot a simple moving average for a 5-day period. You have to record the five-day closing prices. They should look like these:

Day 1 = 1.2345

Day 2 = 1.2350

Day 3 = 1.2360

Day 4 = 1.2365

Day 5 = 1.2370

Based on these closing prices, you should calculate the SMA as:

(1.2345+1.2350+1.2360+1.2365+1.2370)/5 = 1.2358

This would look pretty straightforward. However, assuming that the closing price for Day 2 was 1.2300, your simple moving average would result to lower price. You can easily get the impression that prices are on a downtrend.

The spike on Day 2 however could just be an aberration. There are many factors why prices change radically in a single day. That is why using simple moving averages will not be a good trend indicator especially if there are spikes in prices.

There is a good way however to filter those spikes. It is called Exponential Moving Average and it is a good price indicator so you will not get confused by those spikes.

EMA gives more value to recent prices. If you use the example above, the calculation for EMA would focus more on days 3 to 5. This means the spike would not unduly affect the averages. It also means EMA focuses more on current activities of traders.

At the market, you should know that it is more important to see what the traders are doing currently than on what they did the previous weeks or months.