MOVING AVERAGES

Moving Averages (MA for short) is a very basic indicator known by just

about every trader. If you haven’t heard of it by now then you must really be a newbie to trading. Because of it is so commonly known I won’t go deep into this subject, but will touch upon it for two reasons. (1) To introduce it to those who aren’t yet familiar with it, and (2) to explain the basics of it as it is the foundation of “S.E.X. Lines”, which is dealt with in the next section. Ok, the next few paragraphs are for those of you who are new to trading to understand what an SMA and EMA is. If you already know about these then just skip down a bit to get to the juicy part, or better yet just read it as a little refresher. An SMA, which stands for “Simple Moving Averages” (some folks and charting packages simply refer to this as MA or “Moving Averages” as the “Simple” is just implied) is a basic indicator your charting package will display over your charts. It draws a line showing the average price over the past x number of periods. Lets say you are looking at a one hour chart (each candle represents one hour) and you set your SMA to “10”. What it’ll do then is it will add the closing price of the previous 10 candles and then divide the sum by the number of periods, in this case 10, to find the average price from the past 10 periods (ten hours in this example). This is a simple math procedure you’ve learned to do in elementary school. With each successive period (new candle to the right) it redoes the computation of calculating the average of the past 10 periods by removing the last candle (the now eleventh candle to the left) and adding the newest candle’s price into the average. It keeps redoing this calculation for all the candles displayed on your chart and then plots the average prices onto your chart. Since the prices keep moving, thus changing the average price, the line moves following the current market moves, hence why this is called a Moving Average. The chart below has a green line showing the 10 period SMA. An EMA, which stands for “Exponential Moving Average” is another basic indicator your charting package will display over your charts. Like the SMA described above it also creates a Moving Average price line on your charts however the main difference is that the SMA computes a simple average where each period is valued equally whereas the EMA places more emphasis on the more recent prices. As the more recent prices are valued more than the older prices the “average” price tends to be closer to the current market price. The chart below has a purple line showing the 10 period EMA. What is important to notice is that though both lines show the same moving average period the purple one (EMA) is more responsive to the actual market fluctuations, and you also see that it crosses over the green line (SMA) after the market changes directions.

Some charting packages also have a WMA option. This stands for “Weighted Moving Average”. As explained in the previous paragraph discussing EMA, the WMA places more emphasis on the more recent data but the way it is calculated is different. Feel free to experiment with it if you want, but you’ll find that all you’ll be working with are just the SMA and EMA lines. How are these lines used by traders? There are two common ways (an advanced method is exposed in the next section). Method 1 is that traders pay attention to when the market price crosses over a certain period MA (usually just one line on the chart). Method 2 is that traders pay attention to when a shorter period MA crosses a larger period MA (usually two lines on the chart).

The chart above shows EUR/USD daily candle view. On this chart I’ve put a 50 period SMA (the yellow line) and the 200 SMA (the green line). This is to illustrate “method 1”. Normally a trader would just have one MA line (either simple or exponential), but I’ve put two lines on this chart to contrast different periods. Actually, what I just said is not completely true. Traders often do have multiple MA lines for this method simply to watch when the market penetrates through any of those lines. With “method 1”, traders plot the MA lines on daily charts (usually a SMA) to watch when the market crosses the line. Common daily periods observed by many traders include 50, 100, and 200. Why these numbers? Well some people may give you some nice sounding rational behind these numbers but truthfully they are just nice round arbitrary assignments; you could use weird numbers like 47, 108, and 222 about as effectively. Ok, I’ve heard arguments that 50 and 200 statistically have performed with excellent results to act as significant resistance/support levels, and to some extent would agree from what I’ve observed though I didn’t conduct any statistical analysis myself. A lot of trader’s resource websites make mention of when the market crosses these significant MA lines. Many traders consider penetration of these MA lines to be a significant event. Why? Well just look at those lines on the chart above. Notice that when market touches/crosses the line that soon after the market races off for quite some time (trending) before it eventually reconnects with that same MA line. There are many traders that ONLY trade based upon when the market connects with the MA line. This is such a simple indicator, yet it is sooooooooo very powerful, and if you were to only trade based upon this then you would do quite well for yourself. Earlier on I mentioned that there was another method, “method 2”, of how traders use these MA lines. This simply involves having two MA lines (either simple or exponential) an observing when the two lines cross. The chart below shows EUR/USD hourly candles with a 5 period (yellow) and 20 period (green) SMA. The numbers 5 and 20 are commonly used for this method on various timeframes, but you can play around with other combinations. 

How traders use these crossing pairs of MA lines is they observe when the smaller period line crosses over the larger period line and they attempt to trade in the suggested direction (which way the small line crossed; up or down), and preferably when the market is moving in the direction of the prevalent trend (as you’ll notice that the lines may briefly cross opposite the direction of the trend in retracements). Though many traders are familiar with the concept of this method, most are also familiar with its major drawback – the drawback is that it is a “lagging indicator”. This means that it clearly shows the direction of the market, but only AFTER it has already begun to do so. This indicator has little predictive power, and often once the opportunity is recognized the trader may only jump into a trade late in the game; often too late. That said it does still have value as when properly done a few nice trades can more than compensate for a few losers, or breakeven trades. The next section will explain a technique I’ve developed called “S.E.X. Lines” which takes the concepts discussed above, combines them, and expands upon these concepts to provide a more advanced technique to take advantage of all the individual uses of MA lines. This synergistic combination in fact adds an additional perspective useful to analyzing the actions of the market. Before I complete this section I’d like to point out that though I’ve stated that the MA line methods explained in this section are rather simple and common knowledge to most traders, they are still powerful techniques. Later in this eBook we will revisit and touch upon this subject to see how these concepts

may be integrated with the trading techniques that will be later elaborated upon.