Simple moving averages are calculated in the following way: the sum of closing prices over a specific period of time is divided by the corresponding number of periods. This allows to compute the average price which is ‘moving' regardless of the given time frame (see Figure 1.1).
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Figure 1.1 Three moving averages plotted on a chart
The Dukascopy research team uses the 55-, 100- and 200- hour SMAs for technical analysis.
How do SMAs work?
The simple moving average helps to determine the direction of a trend and a possible change in it. If an SMA is below the price, these points to an up-trend (see Figure 1.3). Conversely, being below the price movement shows a down-trend (see Figure 1.2).
Which SMAs are used by the Dukascopy research team?
1. The 200-hour SMA: This moving average shows how a trend is moving in the long term;
2. The 100-hour SMA: This is the most rarely-used SMA, but it has already proven its usefulness in the foreign exchange market;
3. The 55-hour SMA: This moving average is commonly used to measure the medium-term price movement, thus allowing immediate reaction to the exchange rate movement.
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Figure 1.2 The 200-hour SMA is above the price
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Figure 1.3 The 200-hour SMA is below the price
SMA crossovers
At this point, you should already know how to determine trend movements with the use of simple moving averages. You should also know that SMAs help to indicate when a trend is about to end and reverse to the opposite direction.
When a shorter-term SMA moves above the longer-term moving average, this usually points to a changing trend and therefore provides a buy signal (see Figure 1.5). Meanwhile, a sell signal is given when a shorter-term moving average goes below its longer-term counterpart (see Figure 1.4).
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Figure 1.4 The shorter-term SMA crosses below the longer-term SMA (SELL signal)
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Figure 1.5 The shorter-term SMA crosses above the longer-term SMA (BUY signal)
Conclusion
The simple moving average (SMA) is a simple but nevertheless important technical indicator used by the Dukascopy research team. Plotting these moving averages on the chart helps to determine trend movements and possible price changes. In addition, their crossovers provide early buy and sell signals and thus helps traders to choose the best timing for entering and exiting the market.