How To Use Simple Moving Average (SMA)

The simple moving average (SMA) is the most basic yet powerful technical analysis tool traders and investors use. But what exactly is a simple moving average, and how can you use it when making investment decisions?

This comprehensive guide will explain everything you need to know about calculating and using the simple moving average. Learn what SMA is, how to calculate it, and most importantly - how to utilise it to analyse markets and make profitable trading decisions.

What is a simple moving average?

A simple moving average (SMA) is a technical indicator that shows the average price of an asset over a defined number of periods. As a trend-following or lagging indicator, the SMA relies on past price data to provide insight into the current market conditions.

One of the main functions of the SMA is to help traders identify the underlying trend direction. It can indicate whether an asset is in an uptrend, downtrend, or moving sideways. Aside from that, SMA determine dynamic support and resistance levels. As prices increase or decrease, the SMA adjusts accordingly, providing traders with a clear view of where the market will likely encounter support or resistance. This can be especially useful in volatile markets where prices are prone to sudden swings.

Finally, the SMA is useful for smoothing out price volatility and “noise,” making it easier for traders to identify both entry and exit points in the market. Removing some of the short-term fluctuations in price, the SMA helps traders focus on the broader trend, allowing them to make more knowledgeable trading decisions.

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Calculating a simple moving average

The formula for calculating a simple moving average is easy to understand. Here is the formula:

SMA = (Sum of closing prices over ‘n’ days) / n

Where ‘n’ is the number of periods in the calculation.

Some common periods used for SMA are 10, 20, 50, 100, and 200 days. The timeframes used will depend on your trading style and objectives.

• Short-term traders may use ten or 20-day SMAs to identify quick changes in trend
• Swing traders may opt for 50 or 100-day SMAs to analyse medium-term trends
• Long-term investors might choose 200-day SMAs to identify primary market trends

Traders also use dual or triple simple moving averages, such as combining the 50 and 200-day SMAs. Multiple SMAs of different lengths can help identify crossover points and strengthen trading signals.

Let’s walk through an example of how to calculate a 50-day simple moving average:

• Day 1 closing price: $25
• Day 2 closing price: $27
• Day 3 closing price: $30
• ...
• Day 50 closing price: $31

Add up the 50 closing prices = $1,275

Divide the total by 50 periods = $25.50

The 50-day SMA for this asset equals $25.50. This process is repeated each new trading day, dropping the oldest data point and adding the latest price.

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Using SMA in trading decisions

Identifying trend direction

One of the primary uses of the simple moving average is identifying the prevailing trend direction. By comparing the current price to the SMA line, traders can quickly determine if the asset is in an uptrend or downtrend.

Generally speaking:

• When the price trades above the SMA line, it signals that the asset is in an uptrend. As long as the price remains above the SMA, traders are in a bullish trend and are open for long positions.
• When the price trades below the SMA line, it signals that the asset is in a downtrend. The SMA line will act as dynamic resistance as the price makes lower highs and lower lows. Traders will be in a bearish trend and may take short positions.

It is critical to monitor where the current price action is relative to the SMA line on the chart. This gives traders an immediate visual depiction of the trend. Even during periods of consolidation, traders can identify the prevailing trend bias based on the SMA’s positioning.

Combining SMA with other indicators

For even higher probability trading setups, traders combine SMA signals with other technical indicators. Typical indicators used to confirm SMA signals include:

• Relative Strength Index (RSI)
• Moving Average Convergence Divergence (MACD)
• Stochastic Oscillator
• Average Directional Index (ADX)

Checking that signals from additional indicators align with the SMA crossover adds more evidence that a high probability of successful trade may happen.

Stop loss placement

Placing stop losses is an essential risk management technique. Traders may place stops based on SMA levels:

• For long trades, place stop loss below recent SMA lows
• For short trades, place stop loss above recent SMA highs

Using clear entry and exit criteria streamlines the trading process and removes emotion-driven decisions.

Strengths and weaknesses of SMA

While the simple moving average is an extremely useful indicator, traders should know its advantages and drawbacks before incorporating it into their trading plans. This will help them maximise the benefits of SMA while minimising potential downsides.

Here are the several key strengths that make it a go-to tool for technical analysts:

• Quickly highlights trends and reversals - One glance at an SMA overlay on a price chart makes it easy to spot the current trend direction. Traders can also quickly identify changes in momentum when the price line crosses the SMA. This visual representation of the trend makes analysis straightforward.
• Provides dynamic support and resistance - The SMA line acts as a moving support or resistance level that changes with the trend. This gives traders an easily defined floor or ceiling to monitor when the price approaches a potential reversal. Key SMA levels also provide possible stop loss or take profit targets.
• Generates clear trading signals - Crossovers and overbought/oversold levels on the SMA provide objective entry and exit signals for traders. This removes ambiguity and the need to make discretionary judgment calls.
• Easy to calculate and interpret - The SMA’s simple calculation and single-line display make it understandable for traders at all skill levels. There is no complexity or confusion when analysing SMA data.

Despite its usefulness, the simple moving average also comes with some drawbacks to consider:

• Lagging indicator - By relying solely on past price data in its calculation, the SMA will always lag current price activity to some degree. This can result in late trade signals at turning points. Traders look to minimise lag by using shorter SMA periods.
• Whipsaws - During periods of consolidation or range, the price may whip back and forth across the SMA line. This can generate false reversal signals and unnecessary stops. Traders should look for confirmation before acting on SMA signals.
• No volume data - The SMA only factors in the closing price, ignoring trading volume. This means SMA may generate signals despite weakening momentum. Analysing volume for confirmation provides more insight.
• Subjective input - Choosing the SMA timeframe involves subjective discretion by the trader. Different SMA periods can suggest different interpretations of the trend.

By acknowledging and accounting for the potential drawbacks of using the SMA indicator in trading, traders can effectively leverage the strengths of this remarkable tool. However, it is important to note that SMA is not a foolproof indicator and may be ineffective in all market conditions. Therefore, traders must be mindful of its limitations and use it with other technical analysis tools for the best results.

In summary

The simple moving average is one of the most versatile trading tools for analyzing markets and developing profitable strategies. Its straightforward calculation and clear trading signals make it an ideal indicator for beginners and experts.

However, like with any indicator, the SMA has its limitations. Awareness of the SMA’s strengths and weaknesses allows traders to incorporate it effectively within a robust trading approach. With the proper use of simple moving average analysis, traders have a valuable tool to enhance their market edge. Used prudently, it can serve as a consistent driver of long-term trading success.

Master simple moving averages with markets.com

Enforcing simple moving average strategies requires the right trading platform and tools. Markets.com provides an ideal environment for traders seeking to utilize SMA analysis.

Our demo account allows you to become proficient with SMA before risking real capital. Practice executing trades based on SMA signals and develop confidence in your abilities. With virtual funds, you can trade worry-free as you solidify your skills.

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Our web and mobile platforms are designed with the latest technology to provide you with a seamless trading experience. One of the key features is the intuitive SMA indicator overlay that is available on all instruments. You can easily customize the SMA periods to suit your trading strategy and quickly identify crossover signals.

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When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”