Simple Moving Average – Top 3 Trading Strategies
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Quick Intro Video for How to Trade with the Simple Moving Average
Before you dive into the content, check out this video on moving average crossover strategies. The video is a great precursor to the advanced topics detailed in this article.
So, what is the simple moving average? Once you begin to peel back the onion, the simple moving average is anything but simple.
There are a few additional resources I would like to point out before you proceed with the article; (1) our Trading Simulator (you will need to practice what you have learned) and (2) additional moving average posts to get a broader understanding of the averages (Displaced Moving Average, Exponential Moving Average, Triple Exponential Moving Average).
I think we all recognize the simple moving average is a popular technical indicator. Forget technical analysis, we all were likely using moving averages in our grade school math class.
While we are all familiar with the indicator, why do you think it's so difficult to trade with simple moving averages? If you do a quick Google search you will likely find dozens of day trading strategies, but how do we know which one will work?
Well in this post, I am going to show you everything you need to know about simple moving averages to identify the system that will work best for your trading style. I will inform you through various channels including trade examples, charts, and videos.
In addition, I will also cover a host of topics; to name a few, the simple moving average formula, popular moving averages (5, 10, 200), real-life examples, crossover strategies, and my personal experience with the indicator.
I hope you find this post useful and it helps you in some fashion on your trading journey.
Simple Moving Average Formula
The simple moving average formula is the average closing price of a security over the last "x" periods.
Let's look at a simple moving average example with Microsoft. The last five closing prices for Microsoft are:
28.93+28.48+28.44+28.91+28.48 = 143.24
Quite simply to calculate the simple moving average formula, you divide the total of the closing prices by the number of periods.
5-day SMA = 143.24/5 = 28.65
It is simple addition and division, for the entire world to share.
Popular Simple Moving Averages
Make no mistakes about it, in theory; there is an infinite number of simple moving averages.
If you think you will come up with some weird 46 SMA to beat the market - let me stop you now. It is critical to use the most common SMAs as these are the ones many traders will be using daily.
But don't get me wrong, while I do not advocate you following everyone else, it is essential 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. The shorter the SMA, the more signals you will receive when trading. The best way to use a 5-SMA is as a trade trigger in conjunction with a longer SMA period.
10-SMA - popular with short-term traders; great for swing traders and day traders.
20-SMA - the last stop on the bus for short-term traders.
Beyond the 20-SMA you are looking at primary trends.
50-SMA - used by traders 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 SMASome traders will tell you to try a simple moving average trading system where you buy and sell if price breaks the average on a closing basis. Unfortunately, this is not accurate. Often stocks will tick over or under moving averages to only continue in the primary direction of the trend.
Now that I have given you just enough doubt before even attempting to trade with the simple moving average let's review a few ways to make money with the SMA.
Going with the Primary Trend
- Look for stocks that are breaking out or down strongly
- Apply the following SMAs 5,10,20,40,200 to see which setting is containing price the best
- 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
- Enter the trade on the next bar
Fade the Primary Trend Using Two Simple Moving Averages
- Locate stocks that are breaking out or down strongly
- Select two simple moving averages to apply to the chart (ex. 5 and 10)
- Make sure the price has not touched the 5 SMA or 10 SMA excessively in the last 10 bars
- Wait for the price to close above or below both moving averages in the counter direction of the primary trend on the same bar
- Enter the trade on the next bar
Strategy #1 - Real-Life Example going with the primary trend using the SMA
The simple moving average is probably the most basic form of technical analysis. Even hardcore fundamental guys will have a thing or two to say about the indicator.
A technical analyst must be careful to avoid analysis paralysis because there is an unlimited number of averages and time frames you can choose from.
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 placing a long trade.
The below chart was from TIBCO (TIBX) on June 24, 2011.
I know this is a few years ago, but the market is destined to repeat prior setups; it's all human nature at the end of the day.
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 created during the opening range. In this chart example, we are using the 10-period simple moving average.
Simple Moving Average - When to Sell
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?
What's the magic formula?
Let me help you out here. You would have had no clue.
Far too 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.
Before we go any further, save yourself the time and headache and use the averages to determine the strength of the move.
Now take another look at the chart pattern. Do you see how the stock is starting to rollover as the average is beginning to flatten out?
A breakout trader would want to stay away from this type of activity. Now again, if you were to sell on the cross down through the average, this may work some of the time, but in the long run, you will end up losing money after you factor in commissions.
Why would you lose money? Well in the majority of cases, a break of the simple moving average just leads to choppy trading activity.
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 trading were that easy, everyone would be making money hand over fist.
Next, 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 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 another. Remember, the 20-SMA worked well in this example, but you cannot build a money-making system off one play.
Strategy #2 - Real-Life Example going against the primary trend using the Simple Moving Average
Another way to trade using the simple moving average is to go counter to the trend.
Believe it or not, one of the higher probability plays is to go counter to extreme gap moves.
Regardless of the time in history, (60s flat line, late 90s boom, or volatility of the 2000s), it's a safe assumption that gaps will fill 50% of the time. So, off the bat no matter how new you are to trading, you at least have a 50% shot of being on the right side of the trade using this approach.
But remember this: another validation a trader can use when going counter to the primary trend is a close under or over the simple moving average. In the example below, FSLR had a solid gap of approximately 4%. After the gap, the stock trended up strongly.
You must be careful with countertrade setups. If you are on the wrong side of the trade, you and others with the same 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 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.
Guess what happened?
You got it, the gap filled.
Strategy #3 - Simple Moving Average Crossover Strategy
Moving averages by themselves will give you a great roadmap for trading the markets.
But what about moving average crossovers as a trigger for entering and closing trades? Let me take a clear stance on this one and say I'm not a fan of this strategy.
First, the moving average by itself is a lagging indicator, now you layer in the idea that you have to wait for a lagging indicator to cross another lagging indicator is just too much delay for me.
If you look around the web, one of the most popular simple moving averages to use with a crossover strategy are the 50 and 200 day. When the 50-simple moving average crosses above the 200-simple moving average, it generates a golden cross.
Conversely, when the 50-simple moving average crosses beneath the 200-simple moving average, it creates a death cross.
I only mention this, so you are aware of the setup, which may be applicable for long-term investing. Since Tradingsim focuses on day trading, let me at least run through some basic crossover strategies.
Moving Average Crossovers and Day Trading
Two Simple Moving Average Crossover Strategies
The first thing to know is you want to select two moving averages that are somehow related to one another.
For example, 10 is half of 20. Or the 50 and 200 are the most popular moving averages for longer-term investors.
The second thing is coming to understand the trigger for trading with moving average crossovers. A buy or sell signal is triggered once the smaller moving average crosses above or below, the larger moving average.
Buying on a Cross Up
In the below charting example of Apple from 4/9/2013, the 10-period SMA crossed above the 20-period SMA. You will notice that the stock had a nice intraday run from $424 up to $428.50.
Isn't that just a beautiful chart? The 10-period SMA is the red line, and the blue is the 20-period. In this example, you would have bought once the red line closed above the blue which would have given you an entry point slightly above $424.
Selling a Cross Down
Let's look when a sell action is triggered. In this example, a sell action was triggered when the stock gapped down on 4/15/2013.
Now in both examples, you will notice how the stock conveniently went in the desired direction with very little friction.
Well, this is the furthest thing from reality. If you look at moving average crossovers on any symbol, you will notice more false and sideways signals than high return ones. This is because most of the time stocks on the surface move in a random pattern.
Remember people; it is the job of the big money players to fake you out at every turn to separate you from your money.
With the rise of hedge funds and automated trading systems, for every clean crossover play I find, I can probably show you another dozen or more that don't play out well. This again is why I do not recommend the crossover strategy as a true means of making money day trading the markets.
Simple Moving Average Trading Strategy Case Study Using Cryptocurrencies
If you have been looking at cryptocurrencies over the last six months, you are more than aware of the violent price swings. So, it got me thinking.
Are there any indicators that can give a trader an edge, or is bitcoin so volatile that in the end, everyone loses at some point if you try to actively trade the contract?
This is where I got the bright idea to see how the SMA would hold up against bitcoin.
For this study, I am using the golden cross and death cross strategies, which consists of the 50-period and 200-period simple moving averages. For those of you not familiar with these strategies, the goal is to buy when the 50-period crosses above the 200-period and sell when it crosses below.
To make things more interesting, the study will cover the 15-minute time frame so that we can get more signals.
The study will start on January 26th, 2018 and run through March 29th, 2018.
As you can imagine, there are a ton of buy and sell points on the chart. Now, to be clear, I am not a fan for always staying in the market, because you can get crushed during long periods of low volatility.
The golden cross/death cross strategies on a 15-minute chart generated several trade signals in a little under two weeks.
First Trade Signal
The first trade was a short at 10,765, which we later covered for a loss at 11,270. Herein lies the problem with crossover strategies. If the market is choppy, you will bleed out slowly over time.
Will you Take Every Trade?
Second Trade Signal
I ask this question before we analyze the massive short trade from 10,500 down to 8,465. A challenging part of trading is you must trade every time your edge presents itself. Sounds easy right? Wrong!
That move down is beautiful, and you would have reaped a huge reward, but what is not reflected on this chart are there some whipsaw trades that occurred before the 26th of January.
Do you think you have what it takes to make every trade regardless of how many losers you have just encountered? Oh, how I love the game!
You Will Always Feel Like You Were Sold a Lemon
The other telling fact is that on the second position you would have exited the trade 2,450 points off the bottom. Herein lies the second challenge of trading with lagging indicators on a volatile issue.
By the time you get the trade signal, you could be showing up to the party late.
Third Trade Signal
The next move up is one that makes every 18-year-old kid believe they have a future in day trading - simply fire and forget.
More Trade Signals
After this sell signal, bitcoin had several trade signals leading into March 29th, which are illustrated in the below chart.
Notice how bitcoin is not too choppy, but the gains/losses are small. If you go through weeks of trading results like this, it becomes difficult to execute your trading approach flawlessly, because you feel beaten down.
Due to the volatility of bitcoin, it's apparent that your gainers are far larger than the losers.
Much to my surprise, a simple moving average allows bitcoin to go through its wild price swings, while still allowing you the ability to stay in your winning position. The below infographic visualizes the details of this case study.
My Personal Journey Day Trading Simple Moving Averages
Now that you have all the basics let me walk you through my experience day trading with simple moving averages.
You could be saying to yourself, "Why do I care about this guy's experience? Mine will be different?"
In theory, yes, but there are likely parallels between our paths, and I can hopefully help you avoid some of my mistakes.
#1 - Newbie
It was spring 2007, and I was just starting in day trading.
In my mind volume and moving averages were all I needed to keep me safe when trading. I read all the books and browsed tons of articles on the web from top "gurus" about technical analysis.
From what I could see, price respected the 10-period moving average "all" the time.
I didn't know at this point you see what you want to in charts and for every winning example, there are likely dozens that failed.
If the stock closed below the simple moving average and I was long, I should look to get out. But, if the stock could stay above the average, I should just hold my position and let the money flow to me.
Let's walk through a few chart examples to get a feel for my delusions of grandeur.
I'm not even going to worry about giving you the ticker of the above chart because it's honestly irrelevant.
The point is that I just saw hundreds and I mean hundreds of charts with this pattern.
The pattern I was fixated on was a cross above the 10-period moving average and then a rally to the moon.
I remember feeling such excitement of how easy it was going to be to make money day trading this simple pattern.
Now, shifting gears for a second; anyone that knows me knows that I have a strong analytical mind.
I will review the numbers and then run them all over again to make sure everything nets out.
Hence my second phase on this journey.
#2 - Three Lines
At this point in my journey, it's about the summer of 2007. I am placing some trades and trying different systems, but nothing with great success.
I am using the 10-period simple moving average in conjunction with Bollinger Bands and a few other indicators.
It's not quite a spaghetti chart just yet, but it's a little busy.
So, after reviewing my trades, I, of course, came to the realization that one moving average is not enough on the chart.
The need to put more indicators on a chart is always the wrong answer for traders, but we must go through this process to come out of the other side.
I felt that if I combined a short-term, mid-term and long-term simple moving average, I could quickly validate each signal.
I would use the short=term to pull the trigger when it crossed above or below the mid-term line and the long-term to ensure I was on the right side of the trend.
Did that just confuse you a little?
Let's illustrate this strategy through the chart.
In the above example, the blue line is a 5-period SMA, the red line is a 10-period SMA, and the purple line is a 20-period SMA.
You are welcomed to use any setting that works best for you, but the point is each moving average should be a multiple or two from one another to avoid chaos on the chart.
I used the shortest SMA as my trigger average. When it crossed above or below the mid-term line, I would have a potential trade.
The sign I needed to pull the trigger was if the price was above or below the long-term moving average.
So, going back to the chart the first buy signal came when the blue line crossed above the red and the price was above the purple line. This would have given us a valid buy signal.
Then after a nice profit, once the short line crossed below the red line, it was our time to get out.
Did this mean we should have gone short?
No. Notice that the price was still above the purple line (long-term), so no short position should have been taken.
The purple (long-term) prevents us from always being in a long or short position like in the cryptocurrency case study mentioned earlier.
Looking back many years later, it sounds a bit confusing, but I do have to compliment myself on just having some semblance of a system.
How do you think this all played out?
Don't worry; I'm going to tell you now.
#3 - Buy and Sell Signals
At this point of my journey, I am still in a good place. That's what I was hoping to represent with the green smiley faces. The green also represents the expectation of the money flow as well.
It's around late summer at this point, and I was ready to roll out my new system of using three simple moving averages.
It became apparent to me rather quickly that this was much harder than I had originally anticipated.
First off, it was tough trying to figure out which stocks to pick.
Once I landed on trading volatile stocks, they either gave false entry signals or did not trend all day.
This level of rejection from the market cut deeply. I remember staring at the screen thinking, "Why is this not working?"
Charts began to look like the one below, and there was nothing I could do to prevent this from happening.
What do you think I did next?
That's right, my analytical side kicked in, and I needed to review more data.
Anyone that has been trading for longer than a few months using indicators at some point has started tinkering with the settings. Well, I took that concept to an entirely different level.
I was using TradeStation at the time trading US equities, and I began to run combinations of every time period you can imagine.
I would then run TradeStation's report optimizer to see how things would have worked out.
As you can see, these were desperate times. I was running all sorts of combinations until I felt I landed on one that had decent results.
Now, one point to note, I was running these results against one stock at a time.
The goal was to find an Apple or another high-volume security I could trade all day using these signals to turn a profit.
Similar to my attempt to add three moving averages after first settling with the 10-period as my average of choice, I did the same thing of needing to add more validation checks this time as well.
So, instead of just moving forward with the settings I had discovered based on historical data (which is useless the very next day, because the market never repeats itself), I wanted to outsmart the market yet again.
My path to this trading edge was to displace the optimized moving averages.
This must be painful to read; it surely is painful for me to relive this experience.
It's important to note that I was feeling pretty good after all this analysis. I felt that I had addressed my shortcomings and displacing the averages was going to take me to the elite level.
For those of you not familiar with displaced moving averages, it's a means for moving the average before or after the price action.
You can offset the number of periods higher to give the stock a little more wiggle room.
Conversely, you can go negative on the offset to try and jump the trend.
I'm not going to drain this concept in this article, as the focus of this discussion is around simple moving averages.
The point is, I felt that using the averages as a predictive tool would further increase the accuracy of my signals. This way I could jump into a trade before the breakout or exit a winner right before it fell off the cliff.
To illustrate this point, check out this chart example where I would use the same simple moving average duration, but I would displace one of the averages to jump the trend.
The reality is that I would jump into trades that would never materialize or exit winners too soon before the real pop.
This, of course, left me feeling completely broken and lost. I don't say that lightly.
I mean the feeling of despair was so real; you feel like quitting, to be honest.
I think this feeling of utter disgust and wanting to never think about trading again is part of the journey to consistent profits.
Going back to my journey, at this point it was late fall, early winter and I was just done with moving averages. This is reflected in my red unhappy face.
This of course left me feeling completely broken and lost. I don't say that lightly. I mean the feeling of despair was so real; you feel like quitting, to be honest. I think this feeling of utter disgust and wanting to never think about trading again is part of the journey to consistent profits. Click to tweet
#6 More Indicators
This is the awful curse of technical analysis.
Technical indicators and systems lead to more indicators to try and crack the ever-elusive stock market.
I too fell victim to this horrible symptom of pain from the markets.
This was by far my darkest period of the journey with moving averages.
Not regarding losses, but just in feeling lost with my trading system and overall confidence.
I would try one system one day and then abandon it for the next hot system. This process went on for years as I kept searching for what would work consistently regardless of the market.
This included me trying every indicator from Bollinger Bands, MACD, slow stochastics - you name it, I tried it.
If you get anything out of this article, do not make the same mistake I did with years of worthless analysis. You will make some traction, but it's a far better use of your time to zone in on yourself and how you perceive the market.
#7 - 20 Period Simple Moving Average
After many years of trading, I have landed on the 20-period simple moving average. At times I will fluctuate between the simple and exponential, but 20 is my number.
This is because I have progressed as a trader from not only a breakout trader but also a pullback trader.
I use the 20-period moving average to gauge market direction, but not as a trigger for buying or selling.
It all comes down to my ability to size up how a stock is trading in and around the average.
At times a stock will crack right through the average, but I don't panic that a sell-off is looming. I just wait and see how the stock performs at this level.
After many years of trading, I have landed on the 20-period simple moving average. At times I will fluctuate between the simple and exponential, but 20 is my number.Click to tweet
It's funny to think that I have essentially reverted to exactly what I was looking at over ten years ago - one average.
You may ask "Are you upset that it took you this long to come to this conclusion?"
Absolutely not. It wasn't all death and gloom along the way, and the simple moving average is just one component of my trading toolkit.
In other words, mastering the simple moving average was not going to make or break me as a trader.
However, understanding how to properly use this technical indicator has positioned me to make consistent profits.
Disadvantages of Trading with the Simple Moving Average
There are two disadvantages that come to mind for me when trading with simple moving averages.
The thing is they have little to do with trading or technicals. Both disadvantages for me deal with the mental aspect of trading, which is where most traders struggle - the problem is rarely your system.
Closing Position Remorse
This is something I touched on briefly earlier in this article, essentially with a lagging indicator, you will never get out at the top or bottom. Thinking back to our cryptocurrency example, there were times where we left over 10% or more in paper profits on the table because we did not exit the position.
Now, you could be thinking, well if we make money that is all that matters. Well, if only your brain worked that way.
You could fall into the trap of doing look backs on your trading activity and anguishing at all the loss revenue from exiting too early.
So, how do you fight this demon? How do you let go of the potential that never was meant to be?
Very simple, you let go. You stop obsessing about what you did not receive and start praising and thanking God for what you have!
Yes, I just went there. Trading becomes spiritual as you stretch beyond profits and losses.
The Emotional Toll of Letting Winners Run
The other very real disadvantage is the intestinal fortitude required to let your winners run. You are going to feel all kinds of emotions that are telling you to just exit the position. Or that you have made enough. Or that the pullback is going to come, and you will end up giving back many of the gains.
You must find some way of just charging through all of that and letting the security do the hard work for you. We have been conditioned our entire lives to always work hard towards something.
The market is a lot like sports. A lot of the hard work is done at practice and not just during game time.
When you are in a winner, you must let them run.
Simple Moving Average versus Exponential Moving Average
It would be wrong of me to not go into this a little more as the comparison of the simple moving average to the exponential moving average is a common question in the trading community.
The formula for the exponential moving average is more complicated as the simple only considers the last number of closing prices across a specified range.
The exponential moving average, however, adjusts as it moves to a greater degree based on the price action. To learn more about the exponential moving average and its calculations, please visit the article - 'Why Professional Traders Prefer Using the Exponential Moving Average'.
Now shifting our focus back to the comparison of the two averages, the bottom line is the exponential moving average will stay closer to the price action, while the simple moving average has a slower/smoothed arc.
It is going to come down to your preference. If you like clean charts, stick to the simple moving average. If you feel that you need to try and capture more of your gains, while realizing you may be shaken out of perfectly good trades- the exponential moving average will suit you better.
Below is a charting example that illustrates how each average responds to price.
Are you able to guess which line is the exponential moving average? If it's not obvious, the red line is the EMA. You can tell because even though the SMA and EMA are set to 10, the red line hugs the price action a little tighter as it makes its way up.
As you can see from the chart, the difference in the values isn't anything to call home about.
The price will ultimately respect the line in the same way whether you are using the SMA or EMA. The only time there is a difference is when the price breaks.
What's slightly confusing is that when the price does break, it will likely penetrate the SMA first. This is because the SMA is slower to react to the price move and if things have been trending higher for a long period of time, the SMA will have a higher value than the EMA.
I know that sounds a bit confusing so let's look at a chart example.
As you can see, the EMA (red line) hugs the price action as the stock sells off. But then something happens as the price flattens.
The slower SMA is weighing all the closing prices equally. Therefore, it continues to decline at a faster rate.
Conversely, the EMA accounts for the most recent price movement and begins to climb upwards pulling away from the stock's price as it is in a bottoming formation.
This pulling away by the EMA ultimately results in price breaking the EMA after closing above the SMA.
So, you may be asking yourself, "Well when will the EMA get me out faster?". The answer to that question is when a stock goes parabolic. The EMA will stop you out first because a sharp reversal in a parabolic stock will not have the lengthy bottoming formation as depicted in the last chart example.
So How Do You Trade with the Simple Moving Average?
I'm hoping at this point in the article you can answer this question.
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 of the SMA as a compass. If you want detailed coordinates, you will need other tools, but you at least have an idea of where you are headed.
I know for you the conceptual points are not enough, so let's get literal:
- Only use one simple moving average
- Do not make buy or sell signals based on the price closing above or below the simple moving average
- You should use the simple moving average, as the indicator is arguably the most popular technical analysis tool
- Focus on observing how the stock interacts with the simple moving average, as this is often a head fake tool for algorithms and more sophisticated traders
- Test out the strategies detailed in this article using the Tradingsim platform. We have been able to help countless traders improve their results by providing a risk-free environment to practice trading on the most realistic market replay platform in the world.
- Here is a great article which titled 'How to Profit From Moving Averages' which details strategies using the 50 and 200-day moving averages.
- Below is another video on trading with moving averages. It's a little dated but covers a few crossover strategies.