Best Cash Back Forex Rebates. Learn How to Trade Forex: Foreign Exchange (FX) Currency Trading Exponential Moving Average

As we said in the previous lesson, simple moving averages can be distorted by spikes. Well start with an example.

The closing prices for the last 5 days are as follows:

Simple enough, right?

Well what if there was a news report on Day 2 that causes the euro to drop across the board. This causes EUR/USD to plunge and close at 1.3000. Lets see what effect this would have on the 5 period SMA.

Day 3: 1.3164

Day 4: 1.3186

Day 5: 1.3293

The simple moving average would be calculated as follows:

(1.3172 + 1.3000 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163

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 was just a one-time event caused by the poor results of an economic report.

The point were 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 wouldnt get the wrong idea. Hmm Wait a minute Yep, there is a way!

Its 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 the prices of the most recent days, which would be Days 3, 4, and 5.

This would mean that the spike on Day 2 would be of lesser value and wouldnt have as big an effect on the moving average as it would if we had calculated for a simple moving average.

If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders are doing recently.

Lets take a look at the 4-hour chart of USD/JPY to highlight how an SMA and EMA would look side by side on a chart.

Notice how the red line (the 30 EMA) seems to be closer price than the blue line (the 30 SMA). This means that it more accurately represents recent price action. You can probably guess why this happens.

Its because the EMA places more emphasis on what has been happening lately. When trading, it is far more important to see what traders are doing NOW rather what they were doing last week or last month.

source: www.babypips.com