The simplest type of moving average is the simple moving average (SMA).
A simple moving average is calculated by summing the closing prices from the previous “X” period and then dividing that total by X.
Calculating the Simple Moving Average (SMA)
If you were to draw a 5-period simple moving average on a 1-hour chart, you would add the closing prices for the previous 5 hours and divide the total by 5.
Voila! You now have the five-hour average closing price! When you add those average prices together, you obtain a moving average!
To plot a 5-period simple moving average on a 30-minute chart, sum the closing prices of the previous 150 minutes and divide the total by 5.
Most charting software will perform all of the calculations for you. The “how to” on calculating simple moving averages is vital to learn so you can change and tweak the indicator.
Understanding how an indicator works allows you to react and develop new strategies when the market environment shifts.
Moving averages, like practically every other forex indicator, operate with a delay.
Because you’re looking at averages of past price history, you’re really simply viewing the general course of recent price history and the general direction of “future” short-term price action.
Here is an example of how moving averages smooth out the price action.
On the USD/CHF 1-hour chart, we’ve shown three different SMAs. As you can see, the greater the SMA duration, the more it lags behind the price.
The 62 SMA is further removed from the current price than the 30 and 5 SMAs. This is because the 62 SMA adds the closing prices of the previous 62 periods and divides them by 62.
The longer the SMA period, the slower it reacts to price movement.
The SMAs in this chart represent the market’s overall attitude at this time. We can observe that the pair is trending.
Instead of merely looking at the market’s present price, moving averages provide a larger perspective, and we can now predict the overall direction of its future price.
We can use SMAs to determine whether a pair is trending up, going down, or simply range.
The simple moving average has one flaw: it is subject to spikes. When this occurs, we may receive false indications. We may believe that a new currency trend is emerging, yet nothing has changed.
In the following lesson, we will demonstrate what we mean and introduce you to another type of moving average to prevent this issue.
Next Lesson: Exponential Moving Average (EMA) Explained
