Simple Moving Average (SMA)

Have you ever looked at a price chart and noted a price and wondered how traders seem to exhibit the ability to enter or exit the market at will with such certainty? In trading, we do not have crystal balls, but we do have technical indicators to simplify the convoluted nature of price movements.

A Moving Average or Simple Moving Average (SMA) is one of the most utilized tools and is very user-friendly for new traders.

The SMA pulls together random price movements, thus enabling traders to get a better view of an overall trend and trading opportunity. In this article, we will look at what SMAs are, how SMAs work, why traders use SMAs, and how we can practically use them in our trading.

After you've read this article, you will know this vital tool and how you can make smart trading decisions.

What Is the Simple Moving Average (SMA)?

A Simple Moving Average is a popular technical indicator that calculates an asset's average price over a specified period. The term "moving" is used because the calculation can change based on new data coming in, creating a smoothed line in the price chart that reflects the price's short-term fluctuations moving towards a generally prevailing price profile.

For instance, if you were to take a 50-day SMA, the SMA averages the daily closing price of the asset over the previous 50-day period and plots the value on the price chart each time a new closing price is available. This will display to you whether the market is moving upward, downward, or sideways about the average price.

Calculation of the SMA

The calculations for SMA could not be more straightforward:

SMA = (Sum of Closing Prices for N periods)/N

Where:

• Closing Prices = price at the end of the period

• N = number of periods

To obtain a 10-day SMA, you would take the most recent 10-day closing prices, add them together, and divide by 10. After the calculation, you will have one price point plotted. As additional data comes in, the earlier values are "dropped off," and a smoothed line is created and developed.

Interpreting SMA in Trading

The purpose of SMA is to eliminate much of the market noise, and to obtain more clarity to assist investors and traders in seeing the aggregate overall direction of the trend.

Here is a breakdown of some of the features that traders glean from how they apply their SMA:

• When the price is above the SMA → The market is bullish overall, an uptrend could be developing

• When the price is below the SMA →  The market is bearish, a down-trend could potentially be developing.

• When the price crosses over the SMA → This could signal a reversal of trend, and an opportunity for one to take a position.

Set Lengths or Period SMA

There is no "best" length or period of SMA; however, each has a separate purpose:

• Short-Term SMA (5, 10, 20) periods - These lengths are for day-traders or scalpers, whose strategy is to use swift opportunities. 

• Medium-Term SMA (50 or 100) - Swing traders typically find these SMA lengths useful for capturing longer durations of price trends. 

• Long-Term SMA (200) - Long-term investors and position traders will have an SMA length of 200 periods to show them the general direction of the long-term market.

Your trading style, trading time-frame, and risk allowance will dictate the length of your SMAe.

SMA Crossovers: A Strong Trading Signal

Many traders choose SMA for crossover trading strategies. Crossover trading commonly means that two SMAs with different lengths are being used:

• Golden Cross - Occurs when a short-term SMA (e.g., 50-day) crosses above a long-term SMA (e.g., 200-day). This defines the beginning of a bullish trend.

• Death Cross - Occurs when a short-term SMA crosses below a long-term SMA. This can show the beginning of a bearish move.

Crossover techniques are easy to understand and low-risk, allowing traders to see their entry and exit points and avoid emotional, impulsive responses to trading.

SMA as Dynamic Support and Resistance

An advantage of SMA is that it can then be used as dynamic support or resistance:

• Price usually pulls back towards the SMA in an uptrend, touches the SMA, and then moves up from that point.

• Price usually cannot move beyond the SMA in a downtrend. The SMA acts as a ceiling for price.

Traders utilize these areas to time entries and create stop-loss orders, thereby improving accuracy and risk management.

Using SMA with Other Indicators

The SMA is a powerful tool on its own, but can be even more effective when used with other technical tools:

• Relative Strength Index (RSI): Confirms whether the asset is in overbought territory or oversold territory.

• MACD (Moving Average Convergence Divergence): Combines two SMAs to get trend strength and momentum using a combination of SMAs, one longer term and one shorter term.• Support and Resistance Levels: With the SMA being located near these levels, it can confirm the trading signal created by the price.

• Volume Analysis: also allows for confirmation on whether or not like-minded other traders in the market have supported price increases based on the SMA.

Employing multiple indicators reduces false signals and exposes you to more high-probability setups.

SMA vs. EMA: Locating The Right Moving Average

The SMA is not the only moving average used by traders. They use several moving averages. The Exponential Moving Average (EMA) is another popular tool; here are the differences;

• SMA: will treat all periods as equal, meaning that it will react slowly and take longer to show price changes.

• EMA: will give greater weight to more recent prices, as these are more relevant and helpful in defining ranges, which is vital in environments of changing prices during volatility.

The SMA is better suited for longer-term strategies due to its smoother signals, while the EMA is more beneficial to short-term traders with adrenaline-fueled trades.

Common Errors with SMA

Newer traders who see SMA on their charts often have inconsistent results because they misuse it in their strategy. Here are common errors to avoid:

• Using Too Many SMAs: If your chart is cluttered with too many lines, you will be confused. Limit yourself to 2-3, depending on your preference, at most.

• Market Conditions: As a general rule, SMAs generally work well in trending markets, while they will give you a lot of false signals if the market is choppy and heads sideways.

• No Confirmation On Crossovers: even with moving averages, price action itself should always confirm the signal of other indicators.

• Not Adjusting Periods for Timeframe: short-term traders should not be using SMAs in the longer time frame, and vice versa.

By avoiding these common errors, you can set up SMA analysis in a more reliable way.

Real-World Example of SMA

Let's say you are trading a stock that is valued at $100. You plotted a 50-day SMA on your chart and noticed that the price has been bouncing off this line for several weeks, trending higher.

Now, let's say the price goes down and touches your line for whatever reason. It has formed a bullish reversal candle at the SMA Now, you have confirmation that there is probably decent buying strength on this price level.

Now you have an excellent opportunity to enter your trade idea near the SMA, place your stop loss below it, and allow for what you feel is an appropriate risk: reward ratio.

Conclusion

SMA is one of the most versatile and easiest-to-use tools of technical analysis. The most lucrative aspect of using it is that it smooths price data, enabling you to identify market trends and create targeted entry and exit points, which in turn allows you to manage your risk more confidently.

While the physical use of SMA is straightforward, successfully using it with proper analysis will require you to identify how SMA operates in the context of your charts, such as the choice of periods you need to use, simultaneously using SMA with other complementary indicators, and its use across all market conditions.

Whether you are just starting or are in a position to lock in a trading strategy with a schedule, learning how to maximize how you use SMA could truly clarify how prices are flowing for your benefit, thus allowing you a greater chance to spot profitable trades while swing trading, day trading, or scalping.