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What is Simple Moving Trading Strategy - Formula, Characteristics and Crossover

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  • 26 Oct 2023
What is a Simple Moving Average Trading Strategy?

Moving averages stand as foundational indicators in technical analysis, boasting various variations. Among them, the simple moving average (SMA) is the most straightforward to build. Essentially, it represents the average price over a designated period. The term "moving" is aptly applied as this average is plotted incrementally on the chart, bar by bar, creating a dynamic line that shifts along with the changing average value.

A simple moving average is a widely used technical indicator that helps smooth out price data to create a single flowing line. It achieves this by calculating the average price of a stock over a specified period, with each data point having an equal weight. The SMA is commonly used to identify trends and potential reversals in the market.

To calculate a simple moving average, add the price of a security over a specific period and divide that sum by the number of periods. For instance, add the closing prices of a security for the preceding month and then divide the total by the number of days in the month.

The formula is as follows:

SMA= (A1+A2+A3+…+AN) / N

Where:

  • AN represents the price of the asset at the period

  • N denotes the total number of periods

So, for example, if the closing price of a stock over 5 days is INR 100, INR 120, INR 110, INR 130, and INR 150, the 5-day simple moving average would be (100+120+110+130+150)/5 = INR 122.

Given below are the characteristics of a simple moving average:

  • Smoothed Price Representation

Simple moving averages provide a smoothed representation of price data by calculating the average value over a specified period. This characteristic helps filter out short-term price fluctuations, making it easier to identify underlying trends.

  • Equal Weight to Data Points

Each data point within the chosen timeframe carries an equal weight in calculating a simple moving average. This equal weighting ensures that older and newer data contribute equally to the average, avoiding a disproportionate impact on the indicator.

  • Dynamic Trend Identification

Simple moving averages dynamically identify trends in the market. When prices are above the SMA, it indicates an uptrend, while prices below the SMA suggest a potential downtrend. This feature assists traders in recognizing and confirming the prevailing market direction.

  • Flexibility in Timeframes

Simple moving averages are versatile and adaptable to different timeframes. Traders can choose short-term SMAs for more responsiveness to price changes or longer-term SMAs for a broader perspective on market trends. This flexibility makes SMAs applicable to various trading styles.

Given below are the applications of a simple moving average:

  • Trend Confirmation Tool

Traders use the simple moving average to determine whether a security's price is trending upward or downward. The fundamental rule for employing a simple moving average in trading is that a security in an uptrend is the one trading above its simple moving average. In comparison, a security in a downtrend is the one trading below its simple moving average. For instance, a security trading above its 20-day simple moving average indicates a short-term uptrend. On the other hand, a security trading below its 200-day simple moving average indicates a long-term downtrend.

Another analytical application involves comparing a pair of simple moving averages, each spanning different time frames. If the shorter-term moving average is higher than the longer-term moving average, it signals an expected uptrend. Conversely, if the longer-term moving average is above the shorter-term moving average, it signals an expected downtrend.

  • Use as Support and Resistance Levels

Simple moving averages dynamically function as support and resistance levels within the market. Traders frequently observe prices demonstrating a tendency to rebound off the SMA, presenting them with crucial opportunities for entering or exiting positions. This particular attribute fortifies the utility of the SMA in risk management and is a pivotal aspect of strategic decision-making.

When prices approach the SMA, the average acts as a gravitational force, influencing the market sentiment. In an upward trend, the SMA becomes a dynamic support level as prices tend to find stability or bounce back when nearing this moving average. This gives traders a strategic advantage, allowing them to consider the SMA a potential entry point for long positions.

  • Risk Management

Empowered by identifying trends and potential reversals, the Simple Moving Average strategy significantly enhances risk management. Active traders can take advantage of this by setting precise stop-loss orders based on SMA levels, strategically limiting potential losses, and protecting their investment capital.

Traders often use crossing a security's simple moving averages as a trigger signal for trading. The most popular crossovers are bullish, bearish, and moving-average crossovers.

  • In a bullish crossover, the price of a stock moves above its simple moving average after being below it. This movement suggests a correction's end and an uptrend's potential start. The bullish crossover serves as an indicator to initiate a long trade. While it is quite reliable in a trending market, it may falter in a rough or sideways market. Bullish crossovers hold less significance in the case of a long-term downtrend.

  • On the other hand, a bearish crossover is the opposite of a bullish crossover. It happens when a stock's price is below the simple moving average after trading above it. This signals the end of an uptrend and the anticipation of a downtrend. The bearish crossover signals an exit a long trade or enter a short position. Its efficiency may be reduced in a rough or sideways market.

  • Moving-average crossover occurs when a short-term simple moving average crosses over a long-term simple moving average. Examples of moving-average crossovers include the Golden Cross and Death Cross.

In Conclusion

Simple moving average is a versatile and widely adopted tool in financial markets. Beyond trend identification, its role in risk management is particularly significant. By actively utilizing SMAs, you can not only set themselves up for well-informed decisions and timely entries but also implement advanced risk management techniques, safeguarding your portfolios in the ever-evolving landscape of trading.

FAQs on Simple Moving Average

Traders frequently employ simple moving averages to alleviate the fluctuations in price data and technical indicators. The extent of smoothness in the outcome is directly proportional to the duration of the SMA; however, an increase in smoothness also corresponds to a greater lag between the SMA and the source data. Crossing the price over the SMA is a common technique to initiate trading signals.

Day trading strategies find a relatively robust fit in the combination of five, eight, and 13-bar simple moving averages. These settings, tuned with Fibonacci principles, have stood the test of time, demanding interpretive skills for their appropriate application.

Simple moving average exhibits a weakness in its slower responsiveness to rapid price changes commonly observed at market reversal points.

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