Moving averages are one of the most popular technical indicators. They are very convenient for smoothing out price data series and making the identification of the direction of trends easier, something that is especially helpful in volatile markets as the Forex. Because past price data is the core variable of their formula, they are considered as lagging indicators. Therefore, Moving averages better suit for trend following purposes than to predict when a trend is starting or is coming to an end.

With this characteristics in mind, we should first consider moving averages for what they are able to do. This process does not have to be a scientific examination - at least not at this stage. Usually, a simple visual assessment of the moving average can determine if it has the characteristics we need to apply our trading strategy.

The most popular types of moving averages are the simple moving average (SMA), the exponential moving average (EMA) and the weighted moving average (WMA). The first is formed by computing the average price of a currency pair over a specified number of periods. Most moving averages are created using the closing price although it's possible to create moving averages from the open-, the high-, and the low prices
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The above illustration highlights the fact that the indicator lags price action, that is, it's always behind the price. Therefore, when prices are not trending, moving averages can give misleading information. In order to reduce the lag, technicians created an array of other moving averages, the most common being the mentioned exponential and the weighted moving average. EMAs reduce the lag by applying more weight to recent prices relative to older prices, and the WMAs put more weight on the most recent data and less weight on the older data.

At a first glance, the difference between an exponential moving average and a simple moving average looks minimal. Nevertheless, the exponential moving average is consistently closer to the actual price when it is trending.

Which moving average to use will depend on the concept you base your trading method on, as well as how the specific currency pair has reacted to it in the past. The simple moving average obviously has a lag, but the exponential and the weighted moving average may be prone to more volatility and will generate more false alerts. So your role is to take these aspects into account or even think about ways to take advantage of it. Some traders prefer to use exponential moving averages on shorter time frames to capture incipient trends, while others prefer simple moving averages over large time spans for longer positions.

A perfect moving average should therefore have a minimal lag when the price starts trending and at the same time be smooth enough when price action is range bound. But there is no such perfect moving average and we need to favor one attribute at a time: either smoothness or sensitivity. In fact, there is no perfect technical indicator, all of them produce the so called “false” signals.

As a first approach to any indicator you should experiment with it by plotting it on a chart and play with different settings in order to get a feel between the sensitivity of the indicator for a specific currency pair and its reliability as signal generator. Let the dilemma of the sensitivity and the reliability for the analysts: as a trader, your purpose is to find a tool which can help you interpret what you are already seeing in the price action.

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The above EUR/CAD chart doesn't tell you much? Indeed, a moving average alone is probably not the best choice to build a trading strategy. Prior to the decline, the price gyrated above and below its moving average. After the decline, the pair continued its erratic behavior without developing much of a trend, giving no clear signals on what to do and how to profit from the price action.

What about adding a 50 EMA to the chart and use the two moving averages in order to provide entry signals?

Keeping the same chart, we can see the exchange rate trending in-between periods of consolidation. It is sometimes difficult to determine when a trend will stop and a trading range will begin. But notice the trading range periods, the breakouts (both up and down) and the trending periods. Also observe the direction of the moving average crossovers and how they could have been used to point to the direction of the trend.

The faster moving average, which is measured over the shorter period of time, may be used as proxy for price and thereby eliminate the short-term fluctuations in price action. Technical analysts consider the crossover of the fast average above the slow average as a bullish signal and the crossover of the fast average below the slow average as a bearish signal.

Moving averages also form the building blocks for many other technical indicators. This is the case of our next indicator, the moving average convergence divergence (MACD).