Simple Moving Average

This article on simple moving averages will cover a host of topics.  To name a few, we will be discussing the simple moving average formula, popular moving averages (5, 10, 200) and some real-life moving average examples.  There are a few additional resources I would like to point out before you proceed with the article; (1) Trading Simulator (you will need to practice what you have learned) and (2) additional moving average articles to get a broader understanding of the averages (Displaced Moving Average, Exponential Moving Average, Triple Exponential Moving Average).

How to Calculate the Simple Moving Average

The simple moving average (SMA) is the most basic of the moving averages used for trading. The simple moving average formula is calculated by taking the average closing price of a stock over the last “x” periods.

Let’s take a look at a simple moving average example with MSFT.  The last five closing prices for MSFT are:

28.93+28.48+28.44+28.91+28.48 = 143.24

To calculate the simple moving average formula you divide the total of the closing prices and divide it by the number of periods.

5-day SMA = 143.24/5 = 28.65

Popular Simple Moving Averages

In theory there are an infinite number of simple moving averages.  If you are thinking you will come up with some weird 46 SMA to beat the market let me stop you now.  It is important to use the most common SMAs as these are the ones the majority of traders will be using on a daily basis.  While I do not advocate you following everyone else, it is important to know what other traders are looking at for clues.  Below are the most common SMAs used in the market:

5 – SMA – For the hyper trader.  This short of an SMA will constantly give you signals.  The best use of a 5-SMA is as a trade trigger in conjuction with a longer SMA period.

10-SMA – popular with the short-term traders.  Great swing traders and day traders.

20-SMA – the last stop on the bus for short-term traders.  Beyond 20-SMA you are basically looking at primary trends.

50-SMA – use the trader to gauge mid-term trends.

200-SMA – welcome to the world of long-term trend followers.  Most investors will look for a cross above or below this average to represent if the stock is in a bullish or bearish trend.

Basic Rules for Trading with the SMA

Most traders will tell you to trade simple moving average crossovers of and the profits will fall from the heavens. Well, unfortunately this is not accurate. Often time’s stocks will tick over or under moving averages to only continue in the primary direction. This will leave you on the wrong side of the market and down on your positions. Below are a few ways to make money trading the SMA.

Going with the Primary Trend

1. Look for stocks that are breaking out up or down strongly
2. Apply the following SMAs 5,10,20,40,200 to see which setting is containing price the best
3. Once you have identified the correct SMA, wait for the price to test the SMA successfully and look for price confirmation that the stock is resuming the direction of the primary trend
4. Enter the trade on the next bar

Fade the Primary Trend Using Two Simple Moving Averages

1. Locate stocks that are breaking out up or down strongly
2. Select two simple moving averages to apply to the chart (ex. 5 and 10)
3. Make sure the price has not been touching the 5 SMA or 10 SMA excessively in the last 10 bars
4. Wait for the price to close above or below both moving averages in the counter direction of the primary trend on the same bar
5. Enter the trade on the next bar

Video of  a Simple Moving Average Strategy

The below video shows an example of a simple moving average crossover strategy.  While this trade would have worked in your favor, please remember this is not always the case.

 

Real-Life Example going with the primary trend using the SMA

The simple moving average is probably one of the most basic forms of technical analysis.  Even hard core fundamental guys will have a thing or two to say about the indicator.  A trader has to be careful, since there are unlimited number of averages you can use and then you throw the multiple time frames in the mix and you really have a messy chart. Below is a play-by-play for using a moving average on an intraday chart.  In the below example we will cover staying on the right side of the trend after putting on a long position.

The below chart is from TIBCO (TIBX) on June 24, 2011.

Notice how the stock had a breakout on the open and closed near the high of the candlestick.  A breakout trader would use this as an opportunity to jump on the train and place their stop below the low of the opening candle.  At this point you can use the moving average to gauge the strength of the current trend.  In this chart example we are using the 10-period simple moving average.

Now looking at the chart above, how do you think you would have known to sell at the $26.40 level using the simple moving average?  Let me help you out here.  You would have had no clue.  Far to many traders have tried to use the simple moving average to predict the exact sell and buy points on a chart.  A trader might be able to pull this off using multiple averages for triggers, but one average alone will not be enough.  So save yourself the time and headache and use the averages to determine the strength of the move.

Now take another look at the chart.  Do you see how the chart is starting to rollover as the average is starting to flatten out.  A breakout trader would want to stay away from this type of activity, since the money in this example grows as the stock increases in price.  Now again, if you were to sell on the cross down through the average, this may work some of the time, but over time you will end up losing money after you factor in commissions.  If you don’t believe me, try simply buying and selling based on how the price chart crosses up or under a simple moving average.  Remember, if it was that easy, every trader in the world would be making money hand over fist.

Let’s take another look at the simple moving average and the primary trend.  I like to call this the holy grail setup.  This is the setup you will see in books and seminars.  Simply buy on the breakout and sell when the stock crosses down beneath the price action.  The below is an intraday chart of Sina Corporation (SINA) from June 24, 2011.  Look at how the price chart stays cleanly above the 20-period simple moving average.

Isn’t that a beautiful chart?  You buy on the open at $80 and sell on the close at $92.  A quick 15% profit in one day and you didn’t have to lift a finger.  The brain is a funny thing.  I remember seeing a chart like this when I first started out in trading and then I would buy the setup that matched the morning activity.  I would look for the same type of volume and price action, only to later be smacked in the face by reality when my play did not trend as well.  This is the true challenge with trading, what works well on one chart, will not work well on the other.  Remember, the 20-SMA worked well in this example, but you can not build a money making system off one play.

Real-Life Example going against the primary trend using the SMA

Another way to trade using the simple moving average is to go counter to the trend.  One of the more higher probability plays is to counter gap moves.  There have been a number of studies regarding gaps.  Depending on the period in the stock market (60s flat line, late 90s boom, or volatility of the 2000s) its a safe assumption that gaps will fill 50% of the time.  Another validation a trader can use when going counter is a close under or over the simple moving average.  In the example below, FSLR had a solid gap of ~4%.  After the gap the stock trended up strongly.

You have to be very careful with counter approaches.  If you are on the wrong side of the trade, you and others with your position will be the fuel for the next leg up. Let’s fast forward a few hours on the chart.

Whenever you go short and the stock does little to recover and/or the volatility dries up, you are in a good spot.  Notice how FSLR continued lower throughout the day; unable to put up a fight.  Now let’s jump forward one day to July 1, 2011 and guess what happened?  You got it, the gap filled.

 

Summary

If you haven’t already figured it out, the simple moving average is not an indicator you can use as a standalone trigger.  Now, that doesn’t mean that the indicator can’t be a great tool for monitoring the direction of a trend or helping you determine when the market is getting tired after an impulsive move.  Think if the SMA as a very basic compass.  If you want detailed coordinates you will need other tools, but you at least have an idea of where you are headed.

Al Hill

Co-Founder, Tradingsim.com

alton@tradingsim.com