Simple Moving Average (SMA) - Trend Following Indicator

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April 8, 2008 by admin

How to Calculate the Simple Moving Average

The simple moving average 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.

For example, the last five closing prices of MSFT over the last 5 days are:

28.93+28.48+28.44+28.91+28.48 = 143.24

5-day simple moving average (SMA) = 143.24/5 = 28.65
 

How to Make Money Trading with the SMA

Most traders will tell you to simply trade the crossover of the simple moving average and the profits will drop from the heavens. Well, unfortunately this is not accurate. Often time's stocks will wick 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

Cons of Using Simple Moving Average

The simple moving average takes the raw average of the last "x" closing prices. The SMA does not weight recent price movements any differently then the first price move in the series. Hence, the simple moving average will lag the price quite often and should never be used to make trading decisions independently of other technical analysis indicators.