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In this post, we will discuss what a Simple Moving Average (SMA for short) is, how to calculate it, what it can tell us about the price action and how the SMA can be used as a tool while trading.
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What is the Simple Moving Average (SMA)?
The Simple Moving Average (SMA) is a technical indicator used in price chart analysis. The SMA is an arithmetic technical indicator and it is calculated for a given time point by summing the price or the previous N periods, and dividing the total by N. The SMA, like other moving average indicators is a lagging indicator.
In short, the value of the SMA for a specific point in time is the average of the previous N price values. The number N depends on the chart you are using the strategy that you are trading with.
For example, if you are looking at the day chart and you are calculating the SMA with N = 3, then this will be called the 3 day SMA. Let us discuss the imaginary stock called NULLX which has the prices close as follows:
- Day 1: $5
- Day 2: $7
- Day 3: $8
- Day 4: $6
- Day 5: $7
- Day 6: $4
- Day 7: $5
In order to calculate the 3 day SMA for this data, we will need to calculate the average for each day on the chart. Hence the name, moving average. Since the 3 day SMA requires 3 past data points, we will not be able to calculate the value on days 1, 2 and 3.
However, starting from day 4, we will be able to make the calculations. Day 4’s SMA will be calculated using data from days 1-3, day 5’s SMA will be calculated using data from days 2-4, and so on.
Now, let us show by example how to make the calculation. For example, day 4’s 3-day SMA will be the sum of closing prices from day 1 to 3, divided by 3. This will be (5 + 7 + 8) divided by 3 which is equal to 6.6667. Doing the same calculation per day will yield the following results:
- Day 1: $5 / 3-Day SMA = N/A
- Day 2: $7 / 3-Day SMA = N/A
- Day 3: $8 / 3-Day SMA = N/A
- Day 4: $6 / 3-Day SMA = (8+7+5)/3 = $6.6667
- Day 5: $7 / 3-Day SMA = (6+8+7)/3 = $7
- Day 6: $4 / 3-Day SMA = (7+6+8)/3 = $7
- Day 7: $5 / 3-Day SMA = (4+7+6)/3 = $5.6667
What does the SMA tell us about the price action
The SMA tells us about the general price trends over a period of time. Since the SMA value is a calculated average value, it is not easily affected by hourly or daily price swings. This can help plot a smoother price chart and allows us to see the “bigger picture”. Therefore, according to the direction of the plotted SMA data, we can tell if a market is in an uptrend or a downtrend.
One of the commonly used SMAs is the 200-Day Moving Average. The moving average is calculated for the data of the past 200 days. Let us see how it would look like on a real stock. Take for example the following chart of the Facebook stock.
The chart shows the daily price closing candles of the stock over a period of months. As you can see, the price can have large fluctuations from day to day. However, the 200 day SMA hardly moves. Only after a longer period of general price drops/increases will you see the direction of the SMA move downwards or upwards.
In the chart, you will see the first arrow pointing to the time when the 200 day SMA line started to point downward. Not only did it signal that the stock is in a downtrend, but was also followed by a period of sharp price drops. The second arrow shows the curve of the SMA starting to point upward, potentially signalling an uptrend.
The SMA is a lagging indicator
It is important to note that the SMA is a lagging indicator. This means that its value is based on past data (since it is calculated from data of the past time period). Therefore, it is not a sound strategy to predict future price action based only on a specific SMA, as an SMA cannot predict future prices.
A better use of an SMA is to confirm suspected trends. For example, if we suspect that we have been in a long term downtrend and the 200 SMA starts to point downward, then we can more confidently say that we have been experiencing a down-trend. However, it does not necessarily mean that a stock or a commodity will continue to drop in price. It merely serves as an indicator, another piece in the puzzle.
Another thing to note is that, the larger the time period that you use in an SMA calculation, the less sensitive the moving average will behave. This means that a 100 day MA will be more sensitive than a 200 day MA and less sensitive than a 50 day MA. Take for example the next chart.
As you can see, the smaller the time period in the SMA, the more frequent the moving average changes. As mentioned, a moving average is a lagging indicator. Therefore, you can deploy smaller moving averages to evaluate shorter term trends and get faster feedback. However, you will be making a trade off. This is because shorter period moving averages use a smaller set of data and provide a less accurate longer term trend evaluation.
Trading strategies involving SMA
Up until now, we have explained what a simple moving average is and what differentiates a shorter period MA from a longer period one. Let us discuss some strategies where an SMA can be used during trading.
SMA as support
In many markets, the SMA behaves as a support line. This means that when the price drops close to that SMA, then there is a high probability that the price will bounce back up off the SMA line. In general, the longer the SMA period is, the stronger is the support and the higher is the probability that the price will bounce back off the SMA.
Take for example the following chart of the FB stock from Oct 2014 till Oct 2016.
We plotted the daily price against the 200 day simple moving average. Notice that everytime the price drops near the 200 day moving average, it bounced back up. This means that the 200 day MA has served as a strong support line for over 2 years. Such drops can serve as entry points in the market as we expect with a high probability that a price increase will occur.
Take in contrast the 50 day moving average. It also served as a support line. But over the same time period, it has served as a weak one, as the price was able to break it more often.
SMA as resistance
Just as an SMA line can serve as a support line, it can also serve as resistance. Take for example the following chart for the price of gold plottet against the 200 day MA.
For more than 2 years, the 200 day SMA served as a resistance line, pushing the price down every time the price gets near the SMA. Again, the longer the SMA period, the stronger the resistance is, and the less likely the price will break above the SMA resistance line. Why is this important to know? Well, when the price gets near the SMA resistance line, one can sell or take a short position. This can be a useful strategy to avoid losses or to make a profit from a downtrend.
Important notes about support and resistance lines
We already explored the importance of an SMA line and how it could serve as support or resistance. But how can we determine how an SMA will behave? Well, we can only make an informed guess.
This is why traders are always putting a close eye on markets when they are close to key moving averages. If you break a support or a resistance line and stay there, then it could be a signal for a change of trends.
While you can never say for certain if a resistance or a support line would hold, one can only say that the more times you try to break a trend-line, the more likely you will break it on the next subsequent try.
For example, the price is more likely to break a resistance line on the 2nd try than on the 1st try, and more likely on the 3rd try than on the 2nd try, and so on.
Crosses between MA lines
Another strategy that you could deploy is utilizing data from crosses between moving averages. For example, a cross between the 200 day MA and the 50 day MA, where the 50 day line becomes above the 200 day MA line is called a Golden Cross. A golden cross often signals that a long term uptrend is coming and the prices are about to move higher.
On the otherhand, if the 50 day MA crosses the 200 day MA and stays below it, then this is called a Death Cross and it signals a downtrend or a bear market.
Keep in mind that these crosses are also lagging indicators. However, they do provide valuable information about the current state of affairs. We will discuss golden crosses and death crosses in more details in a later post.
In this post, we discussed what a SMA is, how to calculate it and what it might indicate. Later, we discussed some examples and strategies where we could use the SMA during trading.