Simple Moving Average: Why SMA is the key to successful trading.

Simple Moving Average (SMA) is an efficient tool that most investors use to define an asset’s trend direction. SMA is popular amongst investors as it is commonly used to smooth out past data values and calculate a security’s average price over a specific period. This way analysts can monitor the behavior of an asset and foresee upcoming trend reversals.

SMA is a technical analysis tool that is used by both short and long-term investors. It can be applied to any chosen time frame and its key role is to filter the market noise so it will present a more readable aspect of the market direction. This article presents the different strategies of SMA, ways to calculate as well as the pros and cons.

What Is a Simple Moving Average (SMA)?

The Simple Moving Average is a technical indicator that is calculated through the average price of the past data values over a specified period. SMA takes the sum of the recent closing prices and divides it by that specific number of data points. It is an arithmetic simple type of Moving Averages. The definition “moving” comes from the fact that its value continuously alternates since the price data change accordingly.

Most investors consider SMA as a significant analysis tool that helps them define current price trends and possible changes in the market. It is considered to be a lagging indicator as it provides investors with information about the past and future of the market. Moreover, it can also take the role of support or resistance during a trend. Thus, depending on if it is an uptrend or a downtrend the SMA may act as a floor (support) or a ceiling (resistance) respectively.

SMA is the simplest MA and is depicted with a line chart. This representation of the Simple Moving Average is a powerful visual tool that allows investors to indicate an asset’s trend. Traders need to keep in mind that if the security’s price is below SMA then a downtrend occurs. Otherwise, if there is an uptrend the price fluctuates over SMA.

Simple Moving Average vs. Exponential Moving Average

Moving Averages (MA) can have various forms including weighted, simple moving average, exponential, etc. The most popular MAs in the market are the exponential moving average (EMA) and the SMA. Both are based on the closing prices of an asset but with a significant difference.

The SMA is the sum of the past data values divided by the total number of those points. It has a significant drawback as it measures all the data points with the same weight. For SMA it doesn’t matter if data points are recent or measured a long period before. Conversely, for EMA current data of a trading period is more significant than the older one and its value is more volatile. Thus, the Exponential Moving Average is changing faster and easier than SMA.

Due to its vast change, EMA does not represent a clear perspective of resistance and support levels. SMA is considered to be more stable and credible as it expresses a true average of prices for a particular period. However, the latter is considered to have more lag as it is less responsive to price changes. Last but not least, as EMA gives more importance to more current data it stays closer to the price line, which makes it more reactive and precise.

How Does Simple Moving Average Work?

SMA can be applied in different ways in the market. As a technical indicator, it helps investors to specify the trend direction. Most traders calculate the SMA based on the data values of the past 50 or 200 days. Moreover, there is also a difference if the SMA is short or long term. The latter is commonly expressed by a 200-day while a 50 day period typically measures an intermediate trend. The shorter SMA is expressed with periods smaller than 50 days.

Moreover, SMA is commonly used by investors that are interested in trend-following. Trend-followers constantly monitor the direction of the asset’s trend. If the trend goes up they buy otherwise, they sell. The stronger is the market trend the higher is the SMA value and the more profitable may the investment opportunity be.

Some experienced traders monitor the price crossovers. If the price crosses over the SMA line traders need to go long. Otherwise, if the price is below the SMA line they need to go short. The price crossovers are commonly used by traders to identify potential buy or sell signals. Additionally, the crossover can happen between two different SMA lines. This can happen when the lower average value can exceed the highest number of the current stocks price. For example, a great buy opportunity can be spotted when the 50 surpasses the 200 DMA. In the latter, the average price of the stock is smaller than this of the 50 days. Thus, the crossover technique can also work as a risk management indicator.

What Are The Advantages of Using The Simple Moving Average?

The SMA is a very popular technical indicator used by many investors. Below is a list with a brief analysis of the most significant benefits:

• SMA represents the average value of prices in a specific time frame. Thus, it offers a smooth line of the asset’s trend that is not easily influenced by shorter-term price fluctuations.
• Simple Moving Average is commonly used by long-term investors because it can depict the behavior of the market in longer time frames such as weekly, monthly charts.
• It is a powerful tool that helps to define the levels of support and resistance of the market.
• One of the most important pros of the SMA is that it offers a “true” average value over a specific period and smooths out any unforeseen price changes.
• SMA is used to identify potential entry or exit signals using SMA and price crossover strategies.
• It is a significant indicator of an asset’s trend direction, as well as the market’s movement.

What Are The Limitations of Using the Simple Moving Average?

Although Simple Moving Average is more smoothed and not so easily affected by price alterations, it proves to have some significant limitations. SMA is based on historical data. This is why in some cases SMA may not be so accurate with some significant restrictions. Below are listed some of the most well-known weaknesses of SMA:

• The Simple Moving Average uses data values that can be old and do not have high reliability anymore. This is why SMA appears to have a significant level of lag.
• SMA can not be utilized by all asset types. Different securities have various time cycles and are affected in different ways by price volatility.
• Simple Moving Average is less responsive to price changes and weights the same current and past data values. Most short-term traders consider that as a great limitation since it may not predict potential trading signals.

How to Calculate the Simple Moving Average (SMA)

Most traders calculate the SMA based on the time frame of the past 50 or 200 days. The results of those calculations for any asset are available through financial web pages. However, if traders need to calculate the SMA on their own they can use the following simple equation:

Where:

• An is the asset’s price over n periods
• n is the total number of periods

Most investors prefer the SMA because it can be customized since its result depends on the chosen period. In the expression above, traders sum up all the closing prices for a specific period and dive the result by the number of periods. This gives the average value of an asset within a specific time.

For example, if the chosen period is 10 day period and the closing values are the following :

• Week 1 (5 days) : 19, 21, 18, 22, 25
• Week 2 (5 days) : 27, 22, 20, 28, 30

First, you need to sum up the closing prices within 5 days as follows: (27+22+20+28+30 = 127) and diverse it by 5 so the first result will be 25,4. The next data point will be formed by dropping the earliest value and then adding the value of 6th and diverse again by 5. So (28+20+22+27+25)/5 = 24,4. To calculate all data points the same method should be followed until there is no set of 5-day values left.

Essentially, SMA helps to smooth the instability in the market and offers a more transparent view of an asset’s price trend. Thus, if the SMA line is falling then a fall in the price could be expected. Conversely, if the Simple Moving Average indicator points up there is likely to be an increase in the security’s price.

How To Use the Simple Moving Average (SMA)

Simple Moving Average is a trading tool that can be used by investors in two different ways. Some traders use SMA as a trend indicator to foresee the direction that the price of a security is heading.

If the trend of an asset is heading over the SMA line then it’s in an uptrend. Otherwise, the security is in a downtrend. Trend-followers are interested in buying assets that are trending up and selling the ones that are trending down so they will achieve the best profit. However, investors need always to remember that SMA is a lagging indicator. Thus, they need to adjust their investment strategy since the longer is the chosen period the bigger is the lag.

A simple Moving Average can also be used as an indicator of support and resistance level since it represents the true average of prices within a specific period. Last but not least, It can be an efficient tool in different markets like commodities, currencies, stocks, etc.

Essentially, SMA filters the market noise of everyday price movements and offers a more smooth and readable perspective of the asset’s course. This is how traders can raise their profits by comparing medium and long-term trends over a wider time frame.

Simple moving average strategies

There are many different strategies of SMA that are based on market trends and are used by many investors. The most popular that are explained below are the bullish and bearish crossover as well as the SMA crossover.

Bullish Crossover

The bullish crossover happens when an asset’s price stays for a specific period under the SMA line and then it is placed again over it. That indicates that the downtrend has finished and an uptrend is expected. Thus, SMA produces trading signals for investors to go long. Through the trending market, those signals are considered reliable indicators. Conversely, for sideways markets where the price is within stable values, these signals are not so credible and can not monitor any potential fluctuations in the market.

Bearish Crossover

Another trending strategy is the bearish crossover which takes place when the price of an asset is over the SMA line and then it falls below it. As a consequence SMA signals that the uptrend is over and the market is entering a downtrend. Most traders understand the bearish crossover as the time to exit the long market or go short.

SMA Crossover

Except for the two trading strategies that were mentioned before, the SMA crossover is another popular trading mechanism amongst investors. This type of strategy is also known as the golden cross or death cross depending on the position of the short-term SMA in comparison with the long-term SMA.

The SMA crossover is characterized as a golden cross when an asset’s short-term SMA goes over the long-term SMA. Otherwise, a death cross occurs when the short-term SMA falls below the long-term SMA. For each occasion, the security’s price is moving in different directions. The golden cross is considered a bullish signal and the price may continue rising but the death cross is a bearish signal and the price may continue falling.

Conclusion

The Simple Moving Average is a seamless technical tool that is used by investors to monitor the price movement of a given stock. This indicator can work for both short and long-term traders. It is commonly used in the trading world since it can act as support and resistance and it can often identify the direction of the market. In addition, most investors use SMA to spot the potential entry and exit points as well as situations when the trend is heading up or down. Last but not least, what makes SMA so popular is that it can be adjusted in any preferable time frame.