The Moving Average Method. What is SMA?

What is a Simple Moving Average (SMA)?

A Simple Moving Average (SMA), as the name suggests, is the simplest type of moving average. It is calculated by adding up the closing prices over a specified period 'X' and dividing the total by 'X'. Confused? Don’t worry, let’s break it down.

How Does an SMA Work?

To understand how SMAs function, let’s look at an example. Suppose you want to calculate a 5-period SMA on an hourly chart. Simply add the closing prices of the last five hours and divide the total by 5. That’s it! Now you have the average closing price for the last five hours. If you plot these values on a chart, you’ll get a 5-period moving average. It’s that straightforward.

If you were calculating a 5-period SMA on a 10-minute chart, you’d add the closing prices of the last five 10-minute candles and divide by 5. The same logic applies to a 30-minute or 4-hour chart — you add the closing prices for the last five candles of that timeframe and divide by 5. Got it?

Fortunately, most trading platforms calculate SMAs for you automatically. However, understanding how this indicator works is crucial for tailoring it to your trading strategy and adapting to changing market conditions.

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Key Characteristics of an SMA

Like any other indicator, the SMA works with a delay. It is based on past price data, reflecting how prices behaved previously, which can help traders make future predictions. However, it’s important to note that an SMA won’t turn you into a market fortune teller.

How Does an SMA Smooth Out Price Movements?

By averaging price data, the SMA smooths out random fluctuations, giving traders a clearer view of the overall market trend. Let’s take a closer look at how SMAs behave on a chart.

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Observing SMA Behavior on a Chart

On the hourly chart below, we’ve applied three different SMAs with varying periods: 5, 30, and 60.

• The longer the period, the more the SMA lags behind the price.
• Notice how the 60-period SMA lags behind both the 30-period and 5-period SMAs because it averages the last 60 closing prices.

This illustrates how longer SMAs react slower to price changes.

Benefits of SMAs on a Chart

An SMA provides a clearer picture of the market by smoothing out noise, helping traders:

1. Identify dominant trends (uptrend, downtrend, or sideways).
2. Evaluate the broader market dynamics beyond immediate price fluctuations.
3. Make informed predictions about future price movements.

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Limitations of the SMA

One notable drawback of the SMA is its sensitivity to price spikes. A sudden price surge or a candle with a long wick can distort the SMA, potentially signaling a false trend reversal when, in reality, no significant change is happening.

To address this issue, traders often combine SMAs with other types of moving averages or indicators to filter out false signals.

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Conclusion: Why Use the SMA?

The Simple Moving Average is an easy-to-understand and widely used tool in trading. It provides traders with valuable insights into market trends and price dynamics, making it an essential part of technical analysis. However, like any other indicator, it works best when combined with other tools to confirm signals and improve accuracy.

 

In the next lesson, we’ll explore another type of moving average designed to handle the limitations of the SMA: the Exponential Moving Average (EMA). Stay tuned to learn how it can refine your trading strategy!