How the simple moving average indicator is typically used
The most common way this indicator is used is to determine the overall trend. Notice the red line that is sloping lower on the chart below. It shows that we are clearly grinding lower over the course of the last several days on the hourly chart in the AUD/NZD pair.
The slope going lower is a function of the average price drifting lower and lower over time. Notice how at the beginning of the chart the 20 SMA was rising, but then the price broke down through the moving average to show that something had changed.
Shortly after that, you’ll notice that a majority of the candlesticks were below the 20 SMA, showing that price had changed from rising over the course of the previous 20 hours to falling.
This shows an overall trend change, and it gives you an idea as to whether you should be long or short a currency pair. In this case, it’s obvious that selling the Australian dollar against the New Zealand dollar was the right way to go. The moving average shows you just how right it was.
For example, at the blue arrow you can see that the market was clearly in an uptrend and pulled back towards the 50 day EMA where we saw the market bounce significantly from that level and continue to go higher.
One way that you could have looked at this is that the 'hammer' that had formed on the daily chart right at the 50 day simple moving average was a sign that buyers were finding dynamic support there. Later on, you can see that the market broke down below the 50-day simple moving average indicator, but then bounced back towards it where the red arrow shows a selling opportunity based upon a massive bearish candlestick.
Later on, it tested the general vicinity of the 50-day simple moving average indicator three times where it sold off each time it got too close to it.
At the very end of the chart the market closed well above the 50 day EMA and then started to rocket to the upside showing the 50 day EMA starting to slope higher, confirming than that the trend has obviously changed for the upside in favor of the Euro instead of sloping lower in favor the British pound like it had been previously.
Another use for simple moving average indicators is to look for 'moving average crossovers'. This typically is used for 'buy and sell signals' and some traders even go so far as to always stay in the marketplace based upon how the signal is showing, either bullish or bearish. That being said, the simplest explanation is that you take a faster moving SMA and plot it with a slower moving SMA on a chart. In this example, we will use the CAD/CHF daily chart.
On the chart, there is the red 20 day simple moving average, and the white 50 day simple moving average.
In a 'moving average crossover system', the idea is that as the quicker moving average rises above the slower one, shorter-term traders are starting to come in and momentum is moving to the upside. At that point, traders will buy the market.
On the other hand, when the faster moving average dips below the longer-term moving average, then it shows that short-term traders are starting to push momentum to the downside, and it becomes a sell signal. In this scenario, you buy when the indicator of the shorter time frame breaks higher, and you sell or find yourself short when the lower timeframe indicator breaks underneath.
When you look at this chart, you can see the inherent problem with using this system without any type of filter. There would have been five potential losses before the market finally broke in your direction and would have had you selling into a major breakdown.
One simple filter is to look at the longer-term simple moving average indicator, and what the slope is. For example, in this chart you can see that we were relatively flat for most of this, and that may have kept you out of the market as it shows that we weren’t really trending.
On the final crossover, and the one that the market is currently trading, you can see that the longer-term 50-day EMA started to slope lower, and the two moving averages started to spread out, showing that there was a real divergence between the two time frames, and that momentum was picking up.
In the end, quite often the simple moving average indicator is used with something along the lines of an oscillator in order to determine momentum, and possible diversions. There are other indicators people will use with it, but it seems to be oscillators are by far the most common.