Price Smoothing

Price Smoothing
A moving average is simply a way to smooth out price action over time. By “moving average”,
we mean that you are taking the average closing price of a currency for the last ‘X’ number of
periods.

Like every indicator, a moving average indicator is used to help us forecast future prices. By
looking at the slope of the moving average, you can make general predictions as to where the
price will go.
As we said, moving averages smooth out price action. There are different types of moving
averages, and each of them has their own level of “smoothness”. Generally, the smoother the
moving average, the slower it is to react to the price movement. The choppier the moving
average, the quicker it is to react to the price movement.
Simple Moving Average (SMA)
A simple moving average is the simplest type of moving average. Basically, a simple moving
average is calculated by adding up the last “X” period’s closing prices and then dividing that
number by X.
If you plotted a 5 period simple moving average on a 1 hour chart, you would add up the closing
prices for the last 5 hours, and then divide that number by 5. Voila! You have your simple
moving average.
If you were to plot a 5 period simple moving average on a 10 minute chart, you would add up the
closing prices of the last 50 minutes and then divide that number by 5.
If you were to plot a 5 period simple moving average on a 30 minute chart, you would add up the
closing prices of the last 150 minutes and then divide that number by 5.
Most charting packages will do all the calculations for you. The reason we just bored you
(yawn!) with how to calculate a simple moving average is because it is important that you
understand how the moving averages are calculated. If you understand how each moving average
is calculated, you can make your own decision as to which type is better for you.
Just like any indicator out there, moving averages operate with a delay. Because you are taking
the averages of the price, you are really only seeing a “forecast” of the future price and not a
concrete view of the future. Disclaimer: Moving averages will not turn you into Ms. Cleo the
psychic!

Here is an example of how moving averages smooth out the price action.
On the previous chart, you can see 3 different SMAs. As you can see, the longer the SMA period
is, the more it lags behind the price. Notice how the 62 SMA is farther away from the current
price than the 30 and 5 SMA. This is because with the 62 SMA, you are adding up the closing
prices of the last 62 periods and dividing it by 62. The higher the number period you use, the
slower it is to react to the price movement.
The SMA’s in this chart show you the overall sentiment of the market at this point in time.
Instead of just looking at the current price of the market, the moving averages give us a broader
view, and we can now make a general prediction of its future price.
Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated with it.
Simple moving averages are very susceptible to spikes. Let me show you an example of what I
mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for
the last 5 days are as follows:
Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot
lower and it would give you the notion that the price was actually going down, when in reality,
Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too simple.
If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong
idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our
example above, the EMA would put more weight on Days 3-5, which means that the spike on
Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does
is it puts more emphasis on what traders are doing NOW.

When trading, it is far more important to see what traders are doing now rather than what they
did last week or last month.
Which is better: Simple or Exponential?
First, let’s start with an exponential moving average. When you want a moving average that will
respond to the price action rather quickly, then a short period EMA is the best way to go. These
can help you catch trends very early, which will result in higher profit. In fact, the earlier you
catch a trend, the longer you can ride it and rake in those profits!
The downside to the choppy moving average is that you might get faked out. Because the
moving average responds so quickly to the price, you might think a trend is forming when in
actuality; it could just be a price spike.
With a simple moving average, the opposite is true. When you want a moving average that is
smoother and slower to respond to price action, then a longer period SMA is the best way to go.
Although it is slow to respond to the price action, it will save you from many fake outs. The
downside is that it might delay you too long, and you might miss out on a good trade.
SMA EMA
Pros:
Displays a smooth chart, which eliminates most
fakeouts.
Quick moving, and is good at showing recent
price swings.
Cons:
Slow moving, which may cause a lag in buying
and selling signals.
More prone to cause fakeouts and give errant
signals.
So which one is better? It’s really up to you to decide. Many traders plot several different
moving averages to give them both sides of the story. They might use a longer period simple
moving average to find out what the overall trend is, and then use a shorter period exponential
moving average to find a good time to enter a trade.

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