SMA or simple (or arithmetic) moving average is widely utilized by traders and technical analysts.
The SMA is deemed a highly useful trend indicator and can be considered a fair market price, established by the market itself, thus possessing a significant level of objectivity.
The time intervals of moving averages
An erroneous selection of the order of the average will yield a false signal, thereby potentially leading to losses. As Eric Naiman stated in his work, "The Trader's Little Encyclopedia."
So, which averaging period should one choose?
SMA with super short periods generates lots of false signals, while those with super long periods lag behind significantly. Therefore, traders employ multiple SMAs with different averaging periods simultaneously.
As a swift-moving average, the 5-day SMA (like working days in a week) is frequently used, which is a fair price level. This line on the daily chart helps to determine the start and end of the medium-term trend in time.
If, following an upward trend, you see a black candle that closes below the fifth SMA, it is likely an indication that the price growth has concluded (a sell signal).
If, after a decline, the price breaks above the five-period simple moving average, it indicates that the downward movement has concluded, and a tendency towards growth emerges (a buy signal).
If the candlesticks are positioned directly on the SMA line rather than above or below it, then we are dealing with a sideways market phase, during which one can take a break from trading activities.
Please note!
Try to make trades in the direction of the current trend, at a price as close as possible to the current average or even more favorable. However, if you happen to enter a trade at a price far from the average, despite being in line with the trend, it implies that you entered it merely for the sake of doing something.
Following the same calendar principle, the 20-day SMA is frequently employed, while the universally favored long-term choice is the 200-day moving average. Experienced traders typically have their own customized variations and combinations of averaging, which come from trying and experience. They also use a highly significant trading signal - the crossover of SMAs!
The intersection of moving averages
The simple moving average is a highly comprehensible and accessible indicator. One of its most well-known signals for market entry is the intersection of lines.
Let's take an example and see how this principle can be used for profitable trading!
On the price chart below, you can see 2 SMAs: the blue line for closing prices and, the red one - for opening prices. When the blue line crosses below the red line, we have a price decline with a downward trend. Conversely, when the blue line breaks above the red line, prices rise, indicating an upward trend.
Furthermore, you can see from the chart that as the trend weakens, the price moves closer to the red line rather than the blue line. Attentive traders take this as an opportunity to tighten their stops accordingly.
Two intertwined SMAs serve as poor indicators, indicating that the market can’t make up its mind (flat). However, during a trend, these lines effectively show the current price range. Thus, this chart illustrates two potential opportunities for profit—one from selling and the other from buying, each potentially yielding around a 10% profit within a month.
2 moving averages
Utilizing multiple lines, such as two moving averages with different periods, provides additional opportunities. In this example, it is evident that the SMA10 can assist in determining the level for setting stop-loss orders for the trading signals mentioned earlier.
Additionally, this chart demonstrates an important rule: the stronger the divergence between the moving averages, the stronger the trend. As the trend weakens, the SMAs begin to converge towards each other.
3 moving averages
The slower moving average (with a longer period) typically indicates the overall direction, while the faster one provides signals for buying or selling. To get a complete picture, traders utilize even 3 lines. A long-term moving average, such as the SMA200 (orange on the chart), helps determine the asset’s price status over the calendar year. A truly robust asset that may attract a qualified investor to enhance their investment portfolio should be positioned above the SMA200 line.
Analysis of simple moving averages
The analysis of simple moving averages complements graphical technical analysis. However, it is crucial to follow the rule - work with SMAs only when they have a clear direction (either upward or downward). When the market is in a flat phase and a trader observes lifeless averages, it is important to understand that during this period, trading based on a trending trading system is not advisable.
SMA is well-suited for analyzing daily and weekly charts. For hourly and minute charts, the use of the Exponential Moving Average (EMA) would yield more precise results.
Happy trading!