Last updated on March 5th, 2020
Moving averages are a technical analysis tool that have been a staple of traders for decades.
There are many types of moving averages that all use different formulas and the easiest one to understand is the simple moving average – the SMA.
What Is The Simple Moving Average Indicator
A moving average is a line used on charts to show the average price of a certain number of days back.
The simple moving average, which is the easiest to calculate, is simply the sum of the past X number of prices divided by the total number of prices in the series.
Simple Moving Average Formula
Specifically, we calculate the SMA as follows using a 5 period average as an example and the closing price data of each day:
- Monday – price is $15.00
- Tuesday – price is $15.25
- Wednesday – Price is $16.00
- Thursday – Price is $15.60
- Friday – Price is at $15.65
We use a formula which is adding all the prices up and dividing the answer by the number of prices, which is 5 in this example.
Here is how you would calculate the present day moving average for this example:
- The sum of all prices is: $77.50
- Divide $77.50 by 5
- The simple moving average would plot at $15.50 on the next open
The plotted price of the average will change on a daily basis to match the current days (or intra-day) bars.
How Does The Simple Moving Average Work?
The SMA is applied to your chart and helps to smooth out the price action that has occurred over the period you have chosen.
The moving average is a mathematical calculation of past price and is a lagging indicator – which means it lags the present day price.
Trend direction is the common use of a SMA and there are several that are most commonly used by traders:
- 10 SMA is will react to price movements quicker due to the short look back period of 10. This may interest shorter term swing traders or day traders
- 20 SMA is often used for the shorter term overall trend direction
- 50 SMA is looked at as an intermediate trend direction
- 100 and 200 simple moving averages are longer term trend direction indicators for trend following traders
If the average price of the SMA is increasing, we will see the line turned to the upside indicating an uptrend
A decreasing SMA will generally point to a down trending market.
How To Use Simple Moving Average In Trading
The SMA is a versatile trading indicator that can form the part of any trading strategy. It can act as a standalone indicator or be used to find the current trend direction and forecast the type of market you may be trading.
It can also form a trading strategy of its own when you add in price action to your decision making process.
Find The Trend Direction With SMA
These chart has four moving averages applied to it from a short term average, to a long term one.
The one you would use to determine trend direction will depend on the type of trader you are. To determine trend direction of your chart, will you:
- Use the slope of the moving average as a determination of trend?
- Trade the direction the price is in relation to the average? If above the average, only long trades for example.
- The white line is the 10 SMA and will be the quickest in reaction to price. Slope and price position signal uptrend
- The 20 SMA is in orange and also shows up trend.
- The green line is the 50 period moving average and while price location shows uptrend, the slope of the moving average is down.
- The 200 SMA is yellow and in both cases, shows a market in a down trend
You would then use this trend determination for your particular trading strategy.
Simple Moving Average Plus Price Action Trading
Using a technical analysis approach to trading is common and many times price action plays a role in a traders approach to the market.
Markets trend, range, and mean revert and we can use the trend and mean reversion mechanics to build an outline of a trading strategy that uses everyday price occurrence.
Let’s look at how to use a single moving average for trading and in this case, we will use the 50 period simple moving average for a more intermediate trend direction.
There is nothing magical about a 50 period and there is no best period to use. It depends on your time horizon for trading.
This stock chart is a good example because we have a few trend direction changes
- Price has come off a down trend as price breaks the 50 SMA to the upside. The slope of the average is sideways and the price action shows a double bottom that is a higher low being put in
- With permission for long trades, especially with an up-slope to the SMA, we look for standard pullback trades to the SMA. This zone has two trades and the second one pulls back into the average plus the previous swing low
- Price forms a trading range but the lower shadows and subsequent basing just below resistance, points to more upside
- This corrective decline to the moving average is full of momentum which we don’t want to see with pullback trades. The same area has another pullback to the 50 SMA and the previous swing low.
Price begins to break down after this but you should be able to see the upside of using price action along with the moving average as a point of reference, to take trades.
We are using a standard pullback pattern into an average price of the last 50 days. Price mean reverts back to the 50 and we can use a variety of trade entry techniques to get into the trade.
Moving Averages – Support and Resistance
Another method used by traders is the belief that a simple moving average acts as support and resistance.
This is a myth.
There is the appearance of support or resistance but remember we are looking at a mathematical formula to calculate a moving average. You can see a good example the moving average “acting” as support in the above graphic at location number three.
This is a chart of crude oil using the 20 period SMA for intra-day trading.
The dashed white lines are showing previous price action/structure extended to the right. You will note that when price seems to find support around the 20 SMA, it is really coming into a place of previous price action.
The highlighted area shows another way a moving average may appear to offer support or resistance.
Price has begun to range so the average price that is being calculated, stays virtually the same. The slowing down of price action allows the moving average to catch up to current price.
Use the moving average, whatever period, to show you zones of opportunity for trading signals and then look left for previous price structure.
Learn A Moving Average Crossover Strategy
We have discussed using a single SMA for a trading strategy but did you know you can combine moving averages?
Using a short term moving average along with a long term average, is a strategy that many traders use.
For this, lets use a 10 period SMA and the 30 period to give us a larger window to allow price to evolve. If we use too short of moving average period settings, we will get so many crossovers that they become meaningless.
Our crossover trading strategy will look something like this:
- The short term SMA crossing the long term SMA to the upside is a bullish sign
- When the short term crosses over to the downside, we are bearish and only looking for a sell signal
- We want pullbacks to at least have a close into the space between the two moving averages to give us potential buy and sell signals
- You can use an average true range to place your stops
- Consider profit targets or trailing your stop loss to lock in profits
This is the daily chart of Euro Futures and the vertical lines highlight trend changes.
To get into trades, we will use trend line breaks and if price does not allow the drawing of one, we will go to horizontal support/resistance levels.
We want to allow the trend direction to confirm so wait for the moving average crossover to occur and we will look for our pullbacks
- Price action was sloppy but when the small candlestick closed over the trend line, we could enter long at market or set a buy stop order over highs
- The trend has changed bearish and our conditions for a pullback are met. We can short at the low of the red candlestick that closed below the trend line
- Pullback criteria met, we can short
- We can see strength in the correction but our trend is intact and our entry trigger, the trend line break, is still in play
- Trend change and this pullback fails into a trading range. We can play a failure test of the lows and go long
You can also set your entry order to the low or high, depending on trend condition, of the candlestick that closed according to our trading plan.
- Trade in the direction of the trend which is determined by the SMA crossover. If the short term average is on top of the long term average, we are bullish. Opposite is for bearish
- We need a candlestick close to be between the two moving averages for trade consideration. This is our buy or sell signal
- Our entry trigger is a break of a trend line or the break of the low or high of the candlestick that gave us our trading signal
- Stop loss can use the average true range or around the swing low or swing high with a buffer zone
- Profits can be taken via moving average cross to the opposite direction, profit targets at 2-3X your risk, or use trailing stops
Ensure you have written out your trading plan and covered all the bases including risk management.
How Should You Trade The Simple Moving Average?
There a many moving average strategies you can use but please keep in mind some important things that we’ve talked about here.
Remember I said that the moving average is just a calculation of the past X number of periods. That is not a trading edge that you should risk money on.
We added in price action using quantifiable market mechanics: pullbacks (mean reversion) and momentum (via breakouts of ranges into trends). Now it starts to make a little more sense as we are using something concrete.
You will trade in the path of least resistance which is the trend – until it ends. This way, unless you are entering when the trend is rolling over, should allow you to manage your trade to lessen risk when price moves in your direction.
As indicated by the charts I have shown, using a moving average as a suggestion of where you should look for trading setups/signals, is a great start. You then look left to see where the price is pulling back into.
Having price pullback into the space between the 2 lines of the crossover strategy, ensures you are seeing an actual pullback occur.
Advanced traders will read the strength of the corrective move as pullbacks that have momentum, are a warning sign of potential failure. This will add another level to your trade outcomes as you will learn what pullbacks have a higher probability of advancing in your direction.
In the end, focus on what price is doing and where it is in relation to past price and the simple moving average you choose.