What is Simple Moving Average (SMA)?

The Simple Moving Average is a very common technical indicator that calculate the mean average of consecutive days prices (the simple moving average of price) or the mean average of consecutive days returns (the simple moving average of return). The simple moving average of stock price usually takes the closing prices.

In this article, I'll show you how to calculate SMA, how to interpret SMA, some example strategies, and other indicators similar to SMA.

How do you calculate Simple Moving Average (SMA)?

The formula for the Simple Moving Average of price:

• SMA = Add the closing prices of an asset over a given period of time / Number of time periods (or data points).

The easiest way to understand SMA is through examples:

• The 10-day SMA (also denoted as SMA(10)) = Add the closing prices over the 10-day time frame / 10.

• If the closing prices over a 10 day window are 5,5,6,7,8,9,10,11,10,9 then the SMA(10) = (5+5+6+7+8+9+10+11+10+9)/10 = 8

• Let’s compare this to the closing prices of a security that doesn’t change much from the baseline price of 5. If the closing prices over a 10 day window are 5,5,6,6,5,6,7,6,5,5 then the SMA(10) = (5+5+6+6+5+6+7+6+5+5)/10 = 56/10 = 5.6

How do you interpret Simple Moving Average (SMA)?

When comparing the two examples above, the SMA(10) makes it clear to see that there is a stronger uptrend in the first stock vs the second stock.

As you can see, the SMA is used in technical analysis to smooth out the daily volatility of price fluctuations and understand the overall price trend of the asset.

The longer the time frame you use for SMA, the more data points are used and hence you can understand the price trend over a longer time period. The 200-day SMA is a very common trading indicator. However, as Investopedia explains, there is a danger to following the crowd.

“One of the most popular simple moving averages is the 200-day SMA. However, there is a danger to following the crowd. As The Wall Street Journal explains, since thousands of traders base their strategies around the 200-day SMA, there is a chance that these predictions could become self-fulfilling and limit price growth.

The Wall Street Journal. "Does Chart Analysis Really Work?" ”

How can you use Simple Moving Average in a stock trading strategy?

One popular strategy is the SMA crossover (moving average crossover) strategy. To do this, you may look at a short-term SMA and compare it with a long-term trend SMA. For example, if the short-term SMA is greater than the long-term SMA, this can indicate an uptrend and a buy signal. This is known as a golden cross. On the other hand, if the short-term SMA is less than the long-term SMA, it can indicate a downtrend and a sell signal. This is known as a death cross.

Composer is a stock trading platform with a community of over 1,000+ user-built strategies on their Discover page. Here's some examples of user-built stock trading strategies that use SMA.

• This strategy “Sideways Market Mod Below the SPY 200d SMA | FINAL | DereckN” (link) compares the current price of SPY to the 200d moving average price of SPY. If this condition is true, the strategy goes into a section called “Dip Buy Strategy”. This price movement crossover could indicate a downward trend and a potential dip opportunity to buy.

• This strategy “Smarter Dividends” (link) has a condition that looks at the 5d moving average of SPY price data and compares it with the 100d moving average of SPY. If the 5d MA > 100d MA, the strategy purchases a variety of real estate and dividend ETFs (VIG, VYM, VNQ, REM), else it stays in a short term treasury ETF (SHV).

What are the limitations of Simple Moving Average (SMA)

SMA uses historical data and as the saying goes, past performance is not an indicator of future performance (SMA is a lagging indicator).

In addition, if there are multiple price swings in a given time period (e.g. choppy price action in the 50-day SMA), the average price won’t truly reveal the price action of the asset. For example, there could be a down swing in the first 25-days but the recent data of the last 25-days shows an upswing. The SMA would not highlight this reversal.

What are similar indicators to Simple Moving Average (SMA)?

Another technical indicator similar to SMA is the Exponential Moving Average (EMA). While SMA places an equal weight on all time periods, the EMA places more weight on more recent time periods. The EMA is an example of a weighted moving average.

Another moving average technical indicator is the Moving Average Convergence/Divergence (MACD). This shows the relationship between two EMA of a securities price.

Sources

• https://www.investopedia.com/terms/s/sma.asp

• https://www.investopedia.com/articles/active-trading/052014/how-use-moving-average-buy-stocks.asp