You will come across the term Simple Moving Average (SMA) on numerous occasions when studying charts. It’s a means of averaging the movement in investment markets to identify short, medium, and long-term trends. There is a hedge between the length of the averaging period, the trendline’s strength, and buy/sell signals.
What is the Simple Moving Average?
The best way to describe the SMA is a series of different subsets using, in this instance, the closing price of an investment market. Some of the more common SMAs include:
Day traders/short-term traders
- 5-day moving average (light blue trendline)
- 10-day moving average (purple trendline)
- 20-day moving average (green trendline)
As you can see on the graph below, the five-day moving average offers the earliest indication of a potential changing trend. However, the 10-day and 20-day moving average flatten volatility even further to create a smoother trendline. Short-term trendlines can send false signals, while long-term trendlines offer stronger signals, but there is a lag.
Longer term traders
- 50-day moving average
- 100-day moving average
- 200-day moving average
Where the moving average calculation period is extended, the trendlines are much smoother. These tend to be more useful for those looking at long-term trends, avoiding short-term fluctuations that may reduce their long-term gains.
The key to using an SMA strategy is to find the best moving averages for your investment requirements. There is no point looking at long-term trends as a lead indicator, if you’re a short-term trader. On the flip side of the coin, short-term trend indicators are of limited interest to long-term traders.
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Understanding How the SMA Works
Many external factors can impact short-term movement in investment markets, such as the E-mini S&P 500 futures market. This could be a short-term political event, disappointing employment figures, expiry day volatility, or unexpected developments on the international front. Many of these issues will be resolved and forgotten within 24-hours, so the key is not to overreact. What is the best way to achieve this?
Using average prices over a specifically defined period will help flatten the curve and reduce the impact of concise term price fluctuations. That is why short-term traders use five, 10- and 20-day moving averages, while longer-term traders may use 50-, 100- and 200-day moving averages. The key to short, medium and long-term investment success is to ride the trend until it turns.
As you can see from the above graphs, the longer the period over which the price is averaged, the flatter the line. The longer the period over which you calculate the moving averages the stronger the signal. However, due to the extended time lag, you may already have missed a significant element of the initial change in trend.
How to Calculate the Simple Moving Average
The act of calculating a Simple Moving Average is straightforward. If we consider a trading period of 30-days, we can calculate the five-day moving average. You can do it like so:
Creating data points
To calculate the five-day Simple Moving Average data points, you do the following:-
|Five-day moving average data points||Calculation|
|One||Add closing prices from day 1 to day 5 and divide by five|
|Two||Add closing prices from day 2 to day 6 and divide by five|
|Three||Add closing prices from day 3 to day 7 and divide by five|
|Four||Add closing prices from day 4 to day 8 and divide by five|
|Five||Add closing prices from day 5 to day 9 and divide by five|
|Six||Add closing prices from day 6 to day 10 and divide by five|
|Seven||Add closing prices from day 7 to day 11 and divide by five|
The data points will give you an average of the last five days closing prices and allow you to identify changing trends. To calculate a 10-day moving average, simply add together the ten previous closing prices, then divide by 10. The best way to think of this is a flattening of the trendline to be less volatile.
Simple Moving Average Trading Strategy
There are numerous ways in which you can use the SMA to trade short-term, medium-term and long-term. Whether you are trading in futures, companies, metals, or any other type of investment, the principle is the same. Using the following graph, we will now take a look at how you can use Simple Moving Averages to your benefit.
A bullish crossover occurs when the share price moves through the SMA into higher ground. As you can see from the first shaded area in the above graph, the first indication of an upturn occurred when the share price moved up through the five day SMA (the blue trendline). This change in trend was confirmed after the index also broke through the 10-day and the 20-day moving average trendlines.
Those looking to acquire futures options on the five-day SMA upturn have the highest potential upside, with significant risk. The risk was that this would be a short-term upturn before returning to the previous downtrend. The 10-day and 20-day simple moving average trendlines, in theory, give a stronger signal, but you may have missed a significant element of the initial upside because of the lag.
A bearish crossover is the exact opposite of a bullish crossover. The share price will initially move down below the five-day SMA, then the 10-day SMA, and finally the 20-day SMA. This is a sign that a previous uptrend has turned and, for many, a signal to close an open position or go short. Again, those reacting to the move down through the five-day SMA have potentially greater benefits but more risk that this is only a short-term downturn. A move down through the 10-day and 20-day SMA strengthens the initial indication of a new downtrend.
In this instance, we know that SMA trendlines the five, 10-and 20-day Simple Moving Averages, indicate a potential new trend. With the bullish crossover and the bearish crossover, the alert to a potential change in trend is triggered as the index level moves through individual trendlines. However, many people also use SMA crossovers as an even stronger indicator that a new trend is emerging.
We have highlighted a number of areas in the above graph where SMA lines have crossed over. If we focus on the initial shaded area, the first sign of an upturn is when the index price moves through the five day Simple Moving Average. However, this change in trend signal is further strengthened as each of the SMA trendlines themselves crossover.
In reality, this is an indicator of growing momentum. The short-term blue trendline moves up through the medium-term purple line, then the long-term green line. It may be that you take out an initial position when the index moves through the five-day moving average and then increase your position as the other SMAs are breached. If you were to wait until the short-term SMA move through the long-term (20-day) SMA, you would have already missed out on a significant element of the upturn.
SMA Advantages & Disadvantages
Simple Moving Average trendlines are an integral part of many investment strategies. While there are numerous advantages, there are some disadvantages, as follows.
|Flatten short-term volatility to create a clearer short-term picture||The shorter the term, the greater the chance of a false signal|
|A potential early indication of changing trend||Short-term trends can reverse quite quickly|
|Using multiple trendlines can strengthen changing trend signals (e.g., five, 10- and 20-day)||Medium to long-term trendlines will lag prices; you may miss out on the initial change in trend|
|Golden Cross/Death Cross emerge where short, medium, and long-term moving trends crossover||Golden Cross/Death Cross events will have a significant lag on the initial change in trend|
When we strip the advantages and disadvantages of Simple Moving Averages to the bare bones, there are a few key points to remember:-
- The shorter the SMA term, the greater the chances of identifying a change in trend at a very early stage. If the signal is correct, then this will maximize your potential returns. However, short-term SMAs are prone to false signals.
- The longer the SMA term, the stronger the change in trend signal, but this will take longer to emerge. Consequently, if depending on a longer-term SMA, you could potentially miss out on a significant element of any change in asset price.
- You need to find an SMA term (or multiple SMA trendlines) that best reflects your appetite for risk and potential rewards.
SMA vs. Exponential Moving Average
When researching Simple Moving Average investment strategies, you will often come across the term Exponential Moving Average (EMA). The graph below illustrates a 10-day Simple Moving Average and a 10-day exponential Moving Average. While they are both based on the previous ten closing prices, the EMA calculation is weighted. Consequently, more recent price movements will have a more significant influence on the EMA trendline than those at the beginning of the ten days. The longer the EMA period, the less influence historical price changes will have on the trendline.
If you require more information regarding the calculation of EMA figures, we have published an article titled:
“Exponential Moving Average (EMA) Explained – Strategies and Tips”
|Trendlines||SMA trendlines give equal weighting to recent and historical price movements||EMA trendlines give a greater weighting to more recent price movements|
|False alarms||The shorter the SMA term, the more chance of a false flag||A greater weighting towards short-term price movements can create numerous false flags|
|Volatility||using the SMA calculation flattens short-term volatility||Short-term volatility is more prominent using the EMA calculation|
|Early signals||There will be a lag using the SMA calculation, depending on the SMA term||The lag effect is reduced using the EMA calculation, with greater weighting given to short-term price movements|
|Non-trending markets||The value of the SMA is reduced in non-trending markets||The value of the EMA is reduced to a lesser extent in non-trending markets|
When researching SMA and EMA investment strategies, you tend to see polarised opinions. The SMA strategy is dependent on reducing the influence of more recent price movements. On the other hand, the EMA strategy gives greater weighting to short-term movements. Many would argue that the EMA strategy is more relevant for short-term traders, looking for very early signals that trends are changing.
Why use the Simple Moving Average?
Whether using a Simple Moving Average, or an Exponential Moving Average, the basis is the same. You are looking to flatten short-term volatility to give a greater insight into short, medium, and long-term trend changes. When looking at a relatively volatile futures price in isolation, it can be challenging to gauge the trend. However, looking at a futures price against staggered Simple Moving Averages will give you an idea of the short, medium, and long-term trends.
When looking at a futures price graph in isolation, it can be challenging to identify a short, medium, or long-term trend. It is handy to have five, 10- and 20-day Simple Moving Averages as these give you a basis on which to consider short-term price movements. Long-term traders may use different SMA terms such as 50-, 100- and 200-day. It really does depend on your investment horizon and your appetite for risk/reward.
It is important to note that whatever SMA terms you use will work best in a trending market. A relatively static market does not work well with Simple Moving Averages. Short-term volatility will have a limited impact due to the lack of volatility previously. While the use of EMA terms will give a greater weighting to short-term price movements, in non-trending markets, this impact is also reduced.
On the flip side, if you believe that stock markets are “wholly efficient,” then today’s futures value is the “real value”. Market efficiency is another hot topic!
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