One of the first things that a trader is taught is that “the trends is your friend,” and you have to “go with the flow.” A simple and highly popular approach which identifies the trend is the moving average. There is probably more money being traded today using moving averages than with all other technical indicators combined.
Popularity is difficult to quantify, but according to a quick review into the free indicator/EA repository of Desynced.net, it is the foremost popular indicator used as a basis for EA and indicator construction:
Moving averages have enjoyed such popularity because they provide the clearest method to identify a trend, smoothing the erratic data to see the trend more clearer.
Simply put, a simple moving average is the average of a currency over a set period of time. For example, a 9 day simple moving average is the average of the last 9 day’s prices. It is calculated by taking the sum of the last 9 days of a currency's close price and then dividing by 9. It is called simple when there is equal weight given to each price over the calculation period. Other types of moving averages are weighted averages and exponentially smoothed averages, which we will discuss later.
There are three critical parts to any moving average:
We will cover each in turn, exploring the variables of each, uncovering their strengths and weaknesses. All these parts must first, however, be placed in context of the vulnerabilities of the moving average itself (its problems with lag, noise and whipsaws), for making the choice between the different methods, lengths and crossover techniques are ways of countering these vulnerabilities.
The moving average is one of the most popular and useful indicators to depict a trend, but one should also be aware of its two inherent vulnerabilities:
Let us show you an example of these vulnerabilities from a screen shot of a 25 daily simple moving average superimposed upon the EURUSD daily chart of 2011:
You can easily see that from Jan to May 1, 2011, the market had remained above the 25-day moving average, which means that it was in a strong uptrend. The moving average would have helped us see the trend and stay bullish on EURUSD for over five months. That is the strength of the moving average and during that time those who followed the trend set by the moving average would have racked up significant gains.
Now let us examine three weaknesses of the moving average over the same period. The first weakness is that when the trend changed direction in early May, the moving average did not show this trend change till 400-500 pips later, until price crossed under the moving average at 1.4300. This is the problem of lag, which means that a significant move will have already occurred before the indicator was able to generate a signal. The second weakness is that in the middle of February the market dipped briefly below the moving average, signaling a false trend change. You can see another false trend change occur earlier in December when the market briefly rose above the moving average. This is the problem of market noise, a term that refers to all the price data that distorts the picture of the underlying trend, such as small corrections and intraday volatility. The third weakness can be seen from May to September 2011, where the market stayed in a sideways, very noisy, very narrow 300 pip range, with the market weaving up and down through the 25-day moving average. This is the problem of a sideways and noisy market. This sideways, noisy period would have represented significant losses for traders employing moving averages as they would have entered and been beaten up on numerous fake trend signals and subsequent stop-outs. Let us go over these three weaknesses in turn.