Technical Analysis Tools: Simple Moving Average (SMA)

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It doesn’t come easier than the SMA says Declan Fallon of Zignals.com

The Chart: AAPL from Zignals.com charting application

What does it all mean?

The SMA measures the average asset price over a period of time and is perhaps the most common trend-tool used. The SMA smoothes price action over a period of time, making it easier to discern trend direction. It can be used with any asset over any timeframe.

How does it work?

An SMA is calculated by adding the closing price for each time period and dividing the total by the number of time periods employed. In an SMA, each time period is given an equal weighting. An individual time period can be a single minute to a  yearly data point – there is no fixed definition. A range of moving averages applied to a single chart can give a picture of trends across different time frames.

The fewer time periods employed in the SMA calculation, the more responsive the moving average is to changes in trend for that time frame.

So what are the signals to look for?

The two commonly used SMAs are the 50-day and 200-day. The 200-day moving average is used to measure the long-term trend, while the 50-day moving average picks out intermediate trends, usually lasting anywhere from 3 weeks to 6 months. When the moving average is rising the trend is bullish, if falling the trend is bearish, and when moving sideways there is no trend in play.

Significant trend changes occur when the short term average crosses a longer term average. When a shorter term moving average crosses above a longer moving average it’s called a ‘Golden Cross’ and signifies a new bullish trend. Likewise, when the shorter term average crosses below the longer it’s called a ‘Death Cross’ and marks a new bearish trend. Crosses accompanied by heavier volume reinforce the importance of the cross.

Traders look to crosses between the 50-day and 200-day SMAs of lead indices to indicate shifts in the long term direction of the market. In strong trending markets, the fastest moving average should lead ahead of slower moving averages. For example, in a bull market a 20-day SMA should have a higher value than a 50-day SMA, and both should be higher than a 200-day SMA.

The reverse is true for a bear market.

When this relationship breaks down sideways price consolidations evolve. For example, a 20-day SMA cross below a 50-day SMA where both values are above a 200-day SMA often results in a more protracted correction.

Another feature of moving averages is their use as support and resistance. Traders will use longer moving averages to gauge trade direction, but look to shorter moving averages, like a 10-day or 20-day SMA, to enter positions. The longer the moving average, the more important its influence as support or resistance. A price test of a 200-day SMA will carry greater weight than a 20-day SMA test.

In events where a shorter term moving average crosses a longer moving average a price test of the next longest moving average may occur. For example, a 20-day cross of a 50-day SMA often leads to a price test of the 200-day SMA.

There is no hard and fast rule as to moving averages to use. Short term trades may consider a 10-day SMA a ‘long term’ moving average. What’s important is to have a reasonable spread of moving averages to help gauge trend.

One situation where trading can become more difficult is when price is trading between 50-day and 200-day SMA. In this scenario price action is squeezed by respective support and resistance as the two moving averages converge.

When do I make my move?

Trend traders can use a mix of moving averages to gauge market direction and enter trades. Momentum traders may look to 10-day or 20-day SMAs as entry points and exit on a cross of a 10-day against a 20-day SMA or a 20-day against a 50-day SMA.

Long term traders may use price tests of a 50-day or 200-day SMA to add to an existing held position and exit the entire position when the 50-day crosses the 200-day SMA.

Moving averages work best when employed with other indicators, particularly indicators associated with volume.

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