Simple Moving Averages

The simple moving average is one of the most primitive trading tools investors have at their disposal. Used for many decades in regulating the price of every financial instrument over time, the simple moving average is used to show how the current price of a currency relates to the average price during the previous X periods.

Of all the moving averages, the simple moving average is…well, the most simplistic. The moving average is plotted as a line chart against another chart type of currency values. Here is an example of a simple moving average set to 10 periods on a chart of the GBPUSD:

You’ll notice several differences between the actual price and the simple moving average:

Simple moving averages are smoother – Because each point on the moving average line is compromised of the average of 50 periods before the current bar (this chart is based on months, so 50 months of data are averaged for each point on the line) the simple moving average does not rise or fall as fast as the price. In effect, the current price is basically a 1 period moving average.

SMAs provide support – Simple moving averages are used by technical and fundamental analysts alike. Toward the left of the chart, you will notice that the price of the GBPUSD pair follows the value of the 50-week simple moving average. Then, the price breaks through, and rallies considerably before the SMA provides additional support. Around 2007, during the financial crisis, the GBPUSD plummets through the moving average, and even today the price of GBPUSD is still far lower than the average price during the 50 weeks previous.

Why use a simple moving average?

Forex traders use a simple moving average for any number of reasons, but most importantly, traders tend to use moving averages as a way to see how the present currency value stands up against the past. As we can see in the GBPUSD chart, the simple moving average shows that the GBP is undervalued compared to the average price over the last 50 weeks.

If we can accept that all currencies ultimately return to the mean, or return to their average, then the price of the Pound in Dollars is historically too low, and the dollar should rebound. There are other methods for trading simple moving averages:

Moving average crosses – Using two moving averages on the same chart allows investors to watch their “crosses.” Moving averages of different period weightings rise and fall, ultimately crossing paths when the short-term moving average rises above or below the long-term moving average. Traditionally, forex traders use a simple moving average of 25, 50, 100, or 200 periods, though some strategies call for odd numbers like 15 or 30 periods.

Price crosses – Traders who use only one moving average often use the simple moving average to confirm buy or sell signals. If the price of a currency pair falls below the moving average, then it is said to be a bearish signal, and investors should short the pair. If the price rises above the moving average, then it is said to be a bullish signal, and investors should buy. Of course, any such strategy should be back and forward tested for profitability, as not every moving average cross will result in a profitable trade.