Understanding The Simple Moving Average

Understanding the Simple Moving Average (And How to Interpret It)

Nick Schmidt

Nick Schmidt is a co-founder of TraderLion and Deepvue with over 10 years of market experience. Since 2017, he has dedicated himself to providing top-quality educational material for investors and traders. Adopting a “less is more” philosophy, he focuses on weekly charts with an emphasis on price and volume.

April 4, 2023

5 min read

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Simple Moving Average Key Concepts

Investors and traders identify trends in the stock market using technical analysis. One popular technical analysis tool is the simple moving average.

In this article, we’ll take a closer look at the simple moving average and how to use it to analyze stock charts. We’ll also discuss the SMA as a trading strategy to help you decide whether it’s the right fit for your trading style.

What is a Simple Moving Average?

A simple moving average (SMA) is a statistical method of analyzing stock prices observed over a given number of days or periods.

SMA computes the average prices and is called the arithmetic mean in statistical speak. The moving average progresses as new data is added daily.

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Note: The moving average is a trading indicator that helps smooth the price swings on a chart for a clearer view of current trends.

The Most Popular Simple Moving Averages

The most popular simple moving averages include the 10-DMA, 21-DMA, 50-DMA, and 200-DMA.

The 10-DMA is the shortest-term average and is used to identify short-term price movements.

The 21-DMA is used at TraderLion as a short to intermediate-term moving average. Often times in a strong market, leading stocks will ride along their 21-DMA, this is called a “Power Trend” as long as the 21-DMA is above the 50-DMA.

The 50-DMA is probably the most well-known and talked about moving average among market technicians. At TraderLion we focus heavily on the 50-DMA, which is intermediate to longer-term. As a position trader, this is the average used to determine the overall technical “health” of a stock. In most cases, a position trader is not interested in a stock trading below this key moving average

The 200-DMA is on almost every trader’s chart. It is considered to be the main moving average in determining overall long-term trends. This moving average is often used as a general guide but since it is so slow it is best coupled with shorter-term moving averages. The 200-DMA is most useful when markets enter a deep corrective state similar to the February 24 – March 19, 2020, corrective market phases.

These moving averages are widely recognized and are considered to be highly reliable indicators of market trends.

How to Calculate the Simple Moving Average

SMA takes a certain number of days (periods) when calculating its value. You can adjust these periods, changing the appearance of the line on the chart.

The longer period you use for the SMA, the smoother the line becomes. Conversely, you’ll get more signals when trading using a shorter SMA, such as a 5-day SMA.

To compute the SMA, you add a subset of prices and divide the total by the number of prices in the subset. Here’s the formula for calculating the SMA where A is the price data, and n is the number of days or periods:

To help you manage your risk we’ve put together a free position size calculator.

An Example Calculation of the Simple Moving Average

Date	Closing Price	5-Day SMA	10-Day SMA
March 17, 2023	155.00	153.38	150.43
March 16, 2023	155.85	152.08
March 15, 2023	152.99	151.03
March 14, 2023	152.59	151
March 13, 2023	150.47	150.81
March 10, 2023	148.50	151.48
March 9, 2023	150.59
March 8, 2023	152.87
March 7, 2023	151.60
March 6, 2023	153.83

Here’s a sample computation for a 5-day SMA covering March 6–10, 2023: (153.83 + 151.60 + 152.87 + 150.59 + 148.50) / 5 = 151.48

Now, this is a solution for a 10-day SMA between March 6–17, 2023: (153.83 + 151.6 + 152.87 + 150.59 + 148.5 + 150.47 + 152.59 + 152.99 + 155.85 + 155) / 10 = 150.43

Technical Significance

An SMA (Simple Moving Average) is a key tool in technical analysis, reflecting the average stock price over a specific period. If the SMA rises, it means prices have generally been going up; if it falls, prices have been declining.

A stock price crossing above its SMA is viewed positively by analysts, signaling a bullish trend. It indicates stronger buying than selling pressure. In contrast, a price drop below the SMA is seen negatively, suggesting a bearish trend or weakness.

SMAs also help identify support and resistance levels, crucial for market strategy. Resistance occurs when a stock price hits the SMA but doesn’t break through. Support is when it touches the SMA but doesn’t fall below. Traders use these levels differently. Some trade within these ranges, while others focus on when these levels break, signaling new trends.

Understanding complex patterns like the Head and Shoulders Pattern is essential in this scenario. It helps spot potential trend reversals, a valuable insight for traders.

Putting It All Together

The Simple Moving Average is one of the most popular technical indicators among traders. It allows them to analyze price over time and determine trends. The key to using moving averages is to identify which ones best fit your trading style and timeframe. Shorter-term traders may focus on the 5 and 21-day moving averages, while longer-term investors might look at the 50 and 200-day primarily. Regardless of which type of trader you are, having a good understanding of the SMA will help you make better trading decisions.

Frequently Asked Questions

A Simple Moving Average (SMA) is a widely-used technical indicator. It calculates the average price of a security over a specified number of periods, such as days or weeks. By smoothing out price fluctuations, the SMA helps traders identify trends and potential support or resistance levels in the market.

The Simple Moving Average is calculated by adding the closing prices of a security for a specific number of periods and dividing the sum by that number. For example, a 10-day SMA is calculated by adding the closing prices of the security for the last 10 days and dividing the result by 10.

While both Simple Moving Averages (SMA) and Exponential Moving Averages (EMA) are used to smooth price data, the main difference lies in the weighting applied to the data. SMA assigns equal weight to all price points, while EMA places more weight on recent data, making it more responsive to recent price changes.

Traders can use the Simple Moving Average in various ways, including identifying trends, support and resistance levels, and potential entry or exit points. When the price is above the SMA, it may indicate an uptrend, while a price below the SMA may suggest a downtrend. Some traders also use crossovers between short-term and long-term SMAs as buy or sell signals.

The Simple Moving Average has some limitations, including its lagging nature and susceptibility to false signals. Due to its calculation method, SMA responds slowly to sudden price changes, which may cause traders to miss timely entry or exit points. Furthermore, it may generate false signals during periods of sideways price movement or when the market is experiencing strong price fluctuations.