The plain form of the [[Moving Averages|moving average (MA)]] is a simple moving average, SMA. This type of technical analysis indicators is depicted as a curve on the price chart, the main task of which is to even (or filter) price changes, in order to show the major price tendencies for a currency pair.
SMA curves approximate the price graph. To understand such curves, it is important to realize the principle of its plotting. For a certain time point along the x-axis in the process of construction a number of recent points are taken into account, depending on the chosen smoothing co-efficient. The value (the price) of all points is summarized, and the result is divided by the coefficient. Therefore, from the mathematical viewpoint, SMA is an arithmetical average. The majority of technical analysis applications make the SMA curves automatically, but the mathematical formula for plotting should still be comprehended.
For the value of the smoothing coefficient n the mathematical formula for SMA is as follows:
SMA = (P(n) + P(n-1) + … + P(1)) / n,
where P(n) – is the closing price of the current timeframe, P(n-1) – the closing price of the previous trading timeframe, and so on.
The bigger the smoothing coefficient is, the more previous trading periods are considered, and the smoother the curve becomes. As it is seen from the formula, each n-point is equally significant in plotting SMA curve. This means that for a certain time point (of the trade period) the current price has a similar importance as the number of previous prices. So, the bigger the coefficient value is, the less SMA curve reminds the price chart. By the curves with the larger coefficient, the long-term trend can be seen, by the trend with a smaller coefficient - a short-term trend is seen. By the angle of the curves inclination, the strength (the speed) of the market move can be observed. Sometimes, to construct the curves for analysis together with closing and opening prices, low and high prices are used.
SMA curves allow forecasting the currency rate change, since they reflect the price movement.
The bigger the SMA smoothing coefficient is, the flatter the curve becomes. The smoother the curve is, the slower it reacts to the market price changes. Therefore, analyzing SMAs with high coefficient, we risk to skip a good opportunity of entering or exiting the market, which will result in profit loss. On the contrary, the less is the SMA smoothing coefficient, the less even the curve is. The less flatter curve responds faster to the market price changes. But analyzing SMAs with low coefficient, we risk taking an untimely decision about entering or exiting the market and bare losses, because such indicator is more influenced by statistical noise - the accidental price pikes. Such pikes happen on Forex when important economical indicators of fundamental analysis are published, or at moments of significant market participants’ interventions. Thus, there is a compromise between a timely position opening and the wrong position opening.
SMA curves are efficient, when a particular trend has formed on the market. If there is no trend, and the trade is kept inside the horizontal diapason, SMA curves can give many false signals, that is why it is irrational to use them. Often, to make a decision, the curves are analyzed all together, when a number of curves with different coefficients are taken for consideration. It is accepted to analyze the inclination angles of the curves, their inter-crossing and crossing of the price chart, the direction (uprising or downfalling), when the crossing happens and a number of other factors. Some of the factors, pointing at the beginning, confirmation or the ending of the tendency are given bellow:
- the strength of the bullish trend is confirmed if the price chart is above the SMA curve; and the bearish strength is confirmed when the price graph is below this curve.
- the turn of the SMA curve upwards with the positive inclination of the price chart denotes a buy signal; while its turn downwards with the negative inclination of the price chart indicates a sell signal.
- the cross by the price curve of the SMA curve in downwards direction (with the inclination of both being negative) is read as a sell signal, the cross upwards (with the positive inclination of both) is read as a buy signal.
- the upcrossing by the long SMA curve of the short SMA curve is considered to be a buy signal, and vice versa.
- assuming which SMA curves are directed upwards or downwards, the type of trend is determined: rising, downfalling (short-term, mid-term, long-term).
- the moments, when there is the largest divergence of the two SMA curves with different parameters, are regarded as a signal for a possible trend change.
SMA curves have one important drawback, i.e. all the prices, composing it, are of the same weight. It would be more logical to give more weight to the recent prices and less weight to the long-standing prices. Such approach could allow avoiding problems of the price chart with flash price changes analysis, which have already been discussed. As such changes would influence more the current time point of SMA curve, and less - the following time points. This approach is shown in the indicators of the exponential and weighted moving average.
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