What Is Simple Moving Average (SMA)? Everything You Need to Know

What Is Simple Moving Average (SMA)? Everything You Need to Know

SMA is typically the simplest moving average to create and is one of the key indicators in technical analysis. The goal of all moving averages is to determine, based on prior prices, the direction in which the price of a security is trending.

Intro

The simple moving average (SMA) is frequently used among technical analysis tools. It is one of the most widely utilized indicators across all financial markets and is primarily used to identify trends. The SMA is a lagging indicator that works by removing peaks and valleys from historical

price data.

Trading with the SMAplots a single line on a candlestick chart to represent the average price of a security over a certain period. Both short-term traders and long-term investors utilize the SMA because it can be tailored to fit different time horizons.

A short-term trader, for instance, would employ the 20-day simple moving average to spot transient price movements. On the other hand, a long-term investor would use the 200-day SMA to pinpoint the long-term trend. All financial markets, including shares, currencies, indexes, and exchange-traded funds, can use (ETFs).

What Is a Simple Moving Average (SMA)?

A stock's average closing price over a certain period is called its Simple Moving Average (SMA). Because the stock price fluctuates frequently, the moving average also fluctuates. It is why the average is referred to as "moving." SMA is typically the most straightforward moving average to create and is one of the key indicators in technical analysis.

The goal of all moving averages is to determine, based on prior prices, the direction in which the price of a security is trending. SMA is a lag indicator because it is created using previous closing prices. It does not forecast future pricing;it just shows a previous trend.

SMA and EMA, or the exponential moving average, are frequently contrasted. The EMA gives more weight to current prices than the SMA, which gives equal weight to all data.

Typically, the SMA line becomes smoother as a result.

Examples of Simple Moving Average

A 50-day SMA is used to display how the price of Amazon's stock (NASDAQ: AMZN) fluctuated over a year in the graph above. The purple line, which represents the 50-day SMA, shows the general pattern of the price movement. Since SMA is an average of prices over a given period, as previously said, it does not respond as sharply as actual prices.

The idea will be demonstrated during the earnings reports in February 2020. Despite Amazon reporting outstanding profits that lifted its stock price and caused it to openat close to $2,000, the SMA remained largely unchanged and very slightly climbed.

A 10-day SMA was employed above. The SMA line tracks price fluctuations a lot more closely than the 50-day SMA seen in the previous chart because it was only created using the stock price data from the preceding 10 days.

A 200-day SMA was utilized above. The line is much smoother and less susceptible to changes in price because it shows the average of the closing prices over the previous 200 days.

How Does Simple Moving Average Work?

Prices from the previous50 or 200 days are averaged to create a simple moving average. You can manually calculate this figure, but most financial websites also have it available, and

your broker's website should also have it.

In trend-following, a simple moving average is frequently employed. Those heading up should be purchased, and trend followers should sell stocks trending down. The stock may be trending upward if the moving average is rising. Recent averages will be higher the stronger a trend is. The price should ideally be greater than the 50 DMA, which is higher than the 200 DMA.

One of the best trading techniques is trend-following, and some studies have shown that it has been influential across a range of asset classes for more than a century. Moving averages are acknowledged as a lagging indicator for trend-following, so if the stock price is higher than the moving average—which is determined from historical data—the stock is already rising higher, and the window of opportunity for profit may be closed.

Some traders keep an eye on price crosses to enter as soon as feasible. When a lower-number average (the current stock price) surpasses or crosses over a high number, this is known as a crossover. For instance, if the stock price was, on average, more fantastic in the most recent quarter than in the previous year, it might be agood idea to buy when the 50 DMA crosses over the 200 DMA.

The accompanying chart shows the stock price crossing the June and August moving average lines. You can plot various moving averages alongside the stock price on a website likestockcharts.com or your broker's website to look for price crosses.

For risk management, crossovers can also be employed oppositely. Moving averages are also used to pinpoint a stock's support and resistance levels. Resistance is a price level the stock is not likely to cross, while support is a price level that is not expected to dip below. A stock is said to have broken out if it has been trending for a while above or below the moving average. Breakouts frequently serve as a trade decision's catalyst.

The simple moving average can be used in many trend-based techniques. Bullish and bearish crosses are two of the most common signals traders watch for. When security prices cross over the SMA after falling below it, this is known as a bullish crossover. This activity denotes the conclusion of the downtrend or correction and the potential beginning of an uptrend. You could start a long trade with a bullish crossover. This indication can be remarkably trustworthy when markets are trending. However, the indicator may be less accurate in detecting market movements in turbulent or sideways markets. When the long-term trend is down, bullish crosses are less significant.

When a security's price trades above the SMA and falls below it, it is known as a bearish crossover.This movement signifies the conclusion of the uptrend and the potential beginning of a downward trend. A bearish crossover can signal to sell long or buy short, depending on the situation. A bearish crossover has less significance in choppy or sideways markets.

How to Use A Simple Moving Average?

The simple moving average can be applied in two significant ways. Trend analysis is the first. At the most fundamental level, traders and investors use the SMA to gauge market sentiment and determine whether a security's price is going upward or downward.

A security trading above its SMA is in an uptrend. In contrast, a security trading below its SMA is a downtrend, according to the fundamental rule for trading with the SMA. For instance, a security trading above its 20-day SMA is considered to be in shorta short-term uptrend. 

On the other hand, security is in a long-term downtrend if it trades below its 20-day SMA. Investors and traders can swiftly examine market movements and identify whether a security is going upward or downward by analyzing the SMA.

Trend shifts can be detected using simple moving averages. They can also be used to determine levels of support and resistance. The SMA frequently offers a dynamic degree of support or resistance during a trend. For instance, security in, a long-term uptrend might periodically retrace a small amount, but the200-day SMA will help. It might help spot shifts in a trend. This approach applies to many markets, including stock markets, indexes, and foreign currency.

How to Calculate The Simple Moving Strategy?

Calculating the simple moving average is not difficult at all. The majority of trading platforms provide tools that can compute the SMA automatically. Because modern charting software instantaneously performs all the calculations, traders will essentially never need to manually add the SMA for their trades. The following formula, however, is helpful for a trader's general knowledge.

To generate the SMA formula, several historical data points are averaged. The most typical type of data used is past closing prices. For instance, the closing prices from the previous 20 days would be added up, then divided by 20, to determine a security's 20-day SMA. Similarly, the closing prices from the last 200 days would be added up and divided by 200 to determine a security's 200-day SMA.

Simple Moving Average Trading Strategies

1. Buying and selling on SMA intersections

Technical traders frequently use SMEs to time their buy and sell orders. When conducting their analysis, they observe where the stock price line crosses the SMA line. Let's revisit the Amazon example using the 10-day SMA line to comprehend it better.

Viewing the graph shown above, it is clear that prices frequently trend upward for a while after crossing the SMA line. Technical traders commonly employ it as a buy indicator.

However, we also observe a brief price downturn when the price crosses over and descends below the SMA line. It could occasionally be a good sign to sell.However, because the SMAis based on past data and lags behind real-time data, investors must exercise caution when attempting to time the intersections. 

2. SMA crossover strategy

Another technical approach for opening and closing trades is the SMA crossover strategy. The technique is carried out by plotting two SMA lines based on two different time frames. Certain traders can better be timing their deals by looking at the points where the lines cross. Simple moving averages of 50 days and 200 days are the most often used moving averages for long-term investors. For shorter-term investors, the 10-day and 20-day SMAs are also often used.

In the image above,10-day (purple) and 20-day (green) SMA lines are used to analyze Amazonfurther. An investor who bought the stock at the time of the 10-day line first rose above the 20-day line would ideally benefit from a two-month rising trend.

The investor would have closed out their position before a few months of an overall downtrend if they had sold it when the 10-day line went under the 20-day line.

Differences Between SMA And EMA 

The degree to which each moving average is sensitive to changes in the data used in its calculation is the main distinction between an exponential moving average (EMA) and a basic moving average. More specifically, the SMA gives all values the same weight, whereas the EMA gives recent prices a higher weighting.

The two averages are comparable because technical traders frequently use them to smooth out price volatility and have the same interpretation. EMAs are the preferred average among many traders. After all, they react more quickly to the most recent price changes than SMAs do because they give recent data a higher weighting than older data.

The most fundamental type is the simple moving average of moving average. It is calculated by multiplying the current data points by the previous data points. Despite being a fairly well-liked technical indicator, the SMA has a significant flaw. According to some traders and investors, the problem is that each data item is given the same weight. They contend that current data should be given more weight because it is more significant than historical data. 

Due to this, some traders and investors like using the exponential moving average, a different type of moving average (EMA).The exponential moving average favors the most recent prices more than the simple moving average (SMA). The main distinction between the SMA and EMA is this. Because the most recent data has a more significant impact on the calculation than the SMA, the EMA is more responsive to it. The EMA'sanalysis is trickier than the SMA's. But like the SMA, most charting programs can construct an EMA line with a single mouse click. Next Generation, our online trading platform, is no exception.

An exponential moving average lends more weight to current prices than a simple moving average, which gives equal weight to all values over aspecific period. Many traders favor utilizing exponential moving averages over basic moving averages because they are frequently thought of as a more timely indicator of a price trend. The 12-day and 26-day exponential moving averages are typically short-term moving averages. To spot long-term trends, the 50-day and 200-day exponential moving averages are employed.

Advantages of Simple Moving Average

The real benefit of the SMA is that it provides a smoothed line that is less likely to whipsaw up and down in reaction to minute, transient price movements. The SMA's flaw is that it takes longer to react to sudden price fluctuations, which frequently occur near market reversal points. Traders or analysts working with charts with larger time horizons, including daily or weekly charts, commonly prefer the SMA. The exponential moving average's benefits are that it reacts to price changes more quickly than the simple moving average since it is weighted to the most recent price changes. Since the EMA identifies trend change more rapidly than the SMA, this is especially beneficial to traders looking to trade intraday swing highs and lows.

Moving averages are a crucial analytical technique for spotting recent price movements and the possibility of a reversal in a long-term trend. Using an SMA to rapidly detect whether an asset is in an uptrend or downturn is the most straightforward application of an SMA in technical analysis. Comparing two simple moving averages covering a different time range is a common analytical application but a little more complicated. An uptrend is predicted if a shorter-term simple moving average is higher than a longer-term average. Conversely, a downtrend can be anticipated if the long-term standard exceeds the shorter-term average.

The death cross and a golden cross are well-liked trading patterns that employ basic moving averages. When the 50-day SMA dips below the 200-day SMA, this is known as a death cross. It is regarded as a negative indication, implying that there will be more losses. The golden cross is formed when a short-term SMA crosses above a long-term SMA. It can indicate future gains because of the large trade volumes.

Limitations of Simple Moving Average

It is uncertain if the most recent days in the period should receive greater attention than farther-off data. Numerous traders think that new data will more accurately capture the current trend the security is following. Nevertheless, some traders believe favoring some dates over others will skew the direction. As a result, the SMA may rely too heavily on old data because it treats the impact of the 10th or 200th day as equal to that of the first or second day.

Similar to this, the SMA only uses historical data. Market efficiency is something that many individuals, including economists, believe in and that knowledge is already fully reflected in current market prices. Using historical data should not provide any insight into asset prices' direction in the future if markets are efficient. The increased sensitivity of the EMA has the concomitant drawback of making it more susceptible to erroneous signals and whipsawing. Intraday traders that trade on shorter time frames, like the 15-minute or hourly charts, frequently employ the EMA.

The Bottom Line

The simple moving average is an effective instrument that can help both short-term traders and long-term investors. The SMA smoothes out price data by averaging a security's price over a predetermined period. It aids in spotting trends and is displayed as a single line on a chart. The SMA's advantage is that it makes it easy for traders and investors to see if security is going upward or downward.

The benefit of the simple moving average is that it is smoother and less prone to many false signals than the EMA. The disadvantage is that part of the information used to calculate the moving average may be out-of-date or stale. However, the EMA and SMA are employed comparably: to spot patterns and pinpoint regions of support or resistance. Either average is often determined by the user's trading strategy or analytical framework because neither average is necessarily superior.