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What is the Simple Moving Average (SMA)?

Synopsis:

The simple moving average (SMA) is an effective and simple tool to predict the movement in an asset’s price. Hence, it is used by all kinds of traders worldwide on a regular basis. Read more..That said, it has its benefits and limitations. It helps smooth out price fluctuations and lets you estimate how the price is likely to move. However, it is slow to react to recent changes in prices. Therefore, it is not good in the short run. Traders should understand its pros and cons well before using it. Read less


The simple moving average (SMA) is a popular stock market indicator that is used by all kinds of participants. It is called a simple average because it is not a weighted average. For example, we can calculate the simple average of a stock’s price over Monday, Tuesday, and Wednesday by simply adding its closing prices over these three days and dividing that by 3.

Now, you may wonder why it is called a moving average. Let us go back to the example we discussed above. Suppose we continue calculating the average of the stock’s price by adding its closing prices on Tuesday, Wednesday, and Thursday and dividing that by 3. Notice that to consider a set of 3 days, we are moving a day forward. So, now we find the average of prices on Wednesday, Thursday, and Friday. We keep on repeating this process of finding the average price. In this manner, we find the simple moving average of a stock’s price.

SMA smooths out fluctuations in day-to-day prices and helps in interpreting price data in a better manner. Hence, it is an extremely useful technical indicator. Now that you know what the simple moving average is, let us dig deeper into this topic.

How to Calculate Simple Moving Average?

In order to calculate the simple moving average (SMA), we need to add the prices of a stock over a period and then divide that number by the number of time periods. Suppose we want to calculate the 5-day moving average of a stock’s price.

Hence, we should find the simple average of its closing prices over 5 days by adding them up and dividing the figure by 5. Further, we should keep on moving one day forward to calculate the simple moving average.

You can calculate the simple moving average by using the following formula:

SMA = (X1 + X2 + …….+ Xn)/n

where:

Xn reflects a stock’s price at period n

n shows the number of total periods.

Let us take an example to understand it further. Suppose, a stock’s price is 10, 12, and 14 on Day 1, Day 2, and Day 3, respectively. Its simple moving average can be calculated as follows:

SMA = (10+12+14)/3 = 12.

Now, its price is 12, 14, and 16 on Day 2, Day 3, and Day 4, respectively. Notice that we are moving a day forward by considering Day 4’s price and excluding Day 1’s price. So, the simple moving average for Day 2, Day 3, and Day 4 can be calculated as shown below:

SMA = (12+14+16)/3 = 14.

The above example shows how we calculate the simple moving average in real-life scenarios. Having discussed how to calculate simple moving average, let us talk about its importance.

Significance of SMA in Technical Analysis

The simple moving average (SMA) is an important technical analysis tool that is also easy to learn and use. It helps us understand the direction in which an asset’s price is likely to move. Hence, we can predict trends in price using SMA.

SMA helps smooth out sharp fluctuations in price data. As we rely on moving averages and not on individual price observations, the price curve tends to have fewer sharp ups and downs, which makes it easier to interpret it for security analysis.

To put it simply, SMA is used by all sorts of market participants because it is effective and simple. Investors use SMA to find trends and also analyse when to buy or sell a security.

SMA also provides traders with important signals that indicate a trend reversal. If a stock’s price is above its 50-day simple moving average, a bullish trend could manifest in it. On the other hand, if the price is lower than the SMA, it may indicate a bearish trend, showing a possibility of a further decline in the price.

More importantly, SMA is also used with other technical indicators to confirm a trend. In fact, it is always a good idea to combine multiple indicators to take a trading call. Relying on only one indicator, whether SMA or any other indicator, can be risky because it can provide you with misleading signals.

Comparing SMA with Other Moving Averages

Whether you are a new trader or an experienced market participant, it is important to understand the difference between simple moving average (SMA) and exponential moving average (EMA). The following table provides this comparison. So, please have a look.

Criteria

Simple Moving Average (SMA)

Exponential Moving Average (EMA)

Method of calculation

SMA is calculated by adding the closing prices of an asset over a certain period and dividing that number with the number of periods.

To calculate EMA, more weight is given to recent prices than to older prices. Hence, more importance is given to recent data.

Weightage

An equal weight is provided to all prices over a certain period to calculate SMA.

Higher weight is provided to recent price points than to older prices to calculate EMA.

Response to price changes

SMA is less sensitive to recent price changes than EMA because it provides equal weight to all price points.

EMA is more responsive to recent price changes than SMA because it gives more weight to recent price points.

Usage

Typically, SMA is used for trend detection in the longer term.

EMA is better for trend detection in the shorter run, as it provides more weight to recent prices.

Lag

SMA has a higher lag than EMA. In other words, it is slower to change than EMA because it provides equal weight to all price points.

EMA has a lower lag than SMA because it provides higher weight to recent observations than to older observations.

When should it be applied?

SMA should be used when the market is relatively stable, with only gradual changes in price.

EMA is a better indicator for a volatile market when we need to react quickly to recent price changes.

Practical Applications of SMA in Trading

Having a theoretical understanding of the simple moving average (SMA) is not enough. So, here is how you can use it in real-life scenarios:

  1. Use it for trend identification: SMA is a simple and effective tool to identify trends in the stock market. If a stock's price remains higher than its moving average on a regular basis, it indicates a bullish pattern, which means that its price may continue to increase. Conversely, if an asset's price is lower than its moving average consistently, it could be a sign to sell it.

  2. Useful with crossovers: At times, a security’s shorter-term SMA is higher than its longer-term SMA. It shows that its recent prices are higher than its older prices, which could indicate a bullish trend in its prices. On the other hand, if a stock’s shorter-term SMA is lower than its longer-term SMA, it may show that its price will remain bearish.

  3. Identify support and resistance levels: If a stock's price is higher than its moving average but occasionally dips down to the moving average only to bounce back, it shows that the SMA is working as a floor for the price. So, it can act as a support level. Along similar lines, if a share's price is less than its moving average; however, it tries to move higher than the SMA but finds it difficult to break above the SMA, then the moving average can act as a ceiling, which means it provides the resistance level.

Limitations of Using Simple Moving Average

While simple moving average (SMA) is a useful tool for traders and investors, it has its limitations, which are important to understand to use it smartly in the stock market:

  1. Tendency to lag: SMA provides equal weight to all price points. Hence, when a security witnesses sharp fluctuations in its price, its SMA is slow to reflect the same because it provides equal weight to recent as well as older observations. In such a case, the exponential moving average (EMA) can be more useful.

  2. Can provide misleading or false signals: When markets are extremely volatile with sharp price swings, SMA may provide misleading signals because it responds quite slowly to recent changes in prices. Hence, it is not a good idea to use SMA in such conditions.

  3. Should not be used alone: SMA should not be used alone because over-reliance on it can provide you with misleading signals, which is the case with other indicators, too. Hence, you should use SMA in conjunction with other indicators.

  4. Limited application in the shorter run: As SMA is slow to react to recent price changes, it has limited application in the shorter run. Instead, it is a better indicator for the long-term.

Implementing SMA in Your Trading Strategy

If you are about to open a trading account to participate in the market, you must learn what the simple moving average is and how to use it. Even if you are a seasoned trader, you should improve your understanding of SMA.

You must begin by learning about the market conditions in which you can implement SMA. For example, SMA is a good indicator when markets are relatively stable. However, it is not a good indicator when markets are choppy.

Then, you must learn to use SMA with other technical indicators because it can provide you with false signals when used alone. Hence, you should not over-rely on it. So, you can certainly implement SMA in your trading strategy. However, you must understand its pros and cons.

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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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