Forex Chart Smoothing.
One of the first things you´ll start to notice once you start staring at charts for a while, is that they can be an incredibly useful tool, but the they can also be an incredibly dangerous tool.
As Disraeli once said (allegedly): “There are three kinds of lies: lies, damned lies, and statistics.”
It´s fine (nay essential) to use forex charts, but you need to know how to use them. And that´s how we get on to chart smoothing- an essential technique that is used to help determine the trend of price movements. Charts record all the spikes of price movements and in order to strip out the noise, forex traders use tools like moving averages to smooth out price movements over time. So instead of looking at price movements by individual time period, we look at closing price averages over a number of periods. The more periods you average out over, the smoother your chart (but also the more data is hidden and the slower the chart s to react to trend reversals etc). As ever, it´s a balance between smoothing out the spikes and revealing the story.
A moving average helps us to predict the future. By analysing the gradient of the moving average chart, you can forecast where the prices are likely to head.
Different Types of Moving Average in Forex Trading
The Simple Moving Average or SMA
As the name suggests, an SMA is the simplest form of moving average. Say you have 5 periods, and you want to run a 5 period SMA. You add the last 5 closing prices together and divide by 5. The chart then “moves along”. For your next average, you would add the latest price and allow the 1st price to drop off.
Any half decent online forex broker should have the charting tools that will do this automatically for you (if they don´t, move on! Find another trader). But it´s important to understand that you are not seeing the actual price, but an average price. Generally, you´ll see the moving average as a trend line superimposed on the pricing. Also remember, that moving averages use historical data to make a prediction of the future- they can´t magically see into the future! If there is an external event that jolts the market, a SMA is not going to be able to predict it any better than you are.
The Exponential Moving Average or EMA
The other main type of moving average used in forex trading is the Exponential Moving Average (EMA).
EMAs give more weight to recent prices- you can vary the amount of weighting- but the general idea is the same. Yesterday´s price has more effect on the average than last weeks (for example). They will tend to react faster to trend switches, meaning you can get into the action earlier. But they might lead you on some wild (and expensive) goose chases). So which one should you use? Well….both! We´ll go into this in a bit more detail later, but you can actually make use of the difference between the 2 moving averages by looking for chart intersections which are also a pointer to trend reversals.