Understanding Simple Moving Averages
When people first know about the concept of technical trading (taking decisions on the basis of price chart patterns and price movements), most people think that they have finally found a sure-shot way to make money in the stock market. However, in reality the technical traders have been searching for the “Holy Grail” in their trading- i.e. they have been looking for a perfect combination of chart indicators, chart patterns and price movements that will always lead to a profitable trade and never give a false signal. This search for Holy Grail is never ending.
However, in current scenario one of the most popular and most useful types of chart patterns to study is the moving average (MA).The moving average is simple to calculate and once plotted directly over the price chart, it is an effective visual trend-spotting tool. Broadly, moving average is classified into three types: simple, exponential and liner.The best way to begin is by understanding the most basic- the simple moving average (SMA).
Here we will discuss SMA in detail and how it can assist traders follow trends in order to earn huge profits.
What is DMA (Simple moving average) in Stock Market?
Simple moving average or DMA commonly used in technical analysis shows the average value of a stock’s price over a particular period. Stocks trading below its 30, 50, 150 or 200 DMA are considered to be stocks that are below their support levels and are expected to fall, on the other hand, stocks trading above their 30, 50, 150 or 200 DMA are considered as stocks that are above their resistance and are expected to rise.
In order to calculate DMA, the closing price of the stocks for a number of time periods is added and then this total is divided by the number of time periods. Many traders look for short-term averages to cross above longer-term averages to show the starting of an uptrend.
Simple Moving Average Formula
The DMA is the simplest of the moving average used for trading. The SMA is calculated by taking the average closing price of a stock over the last “y” periods.
For example, if we talk about the last five closing prices of a listed company then they were noted to be:
28.93+28.48+28.44+28.91+28.48 = 143.24
To calculate the SMA just divide the total of the closing prices with the number of periods.
5 day SMA = 143.24/5= 28.65
Popular Simple Moving Averages
If you are thinking to use some strange 26 SMA to beat the market, then don’t even think about it. It is crucial to use the most common SMAs, as these are the ones that most of the traders use on daily basis.
This doesn’t mean that you should just follow everyone else. It means that it is important to know what techniques or tools other traders are using.
Here we are listing some of the most common SMAs used in the market.
- 5 –SMA: It is used by the hyper trader. The shorter the DMA the more signals you will get when trading.
- 10-SMA: It is popular amongst the short-term traders; perfect for day traders and swing traders.
- 20-SMA: This one is for short-term traders.
- 50-SMA: Traders use this one to gauge mid-term trends.
- 200-SMA: This one is for long-term trend followers. Investors usually look for a cross above or below this average to show if the stock is in a bullish or bearish trend.
Rules for trading with the Simple Moving Average
Most traders will tell you to trade SMA crossovers to reap huge profits. But, sadly, this is not true.
Usually stocks will tick over or under moving averages to just continue in the primary direction. With this you will land on the wrong side of the market and down on your position. Below are a few methods to make money trading the SMA.
Going with the Primary Trend
- Find stocks that are breaking down or out strongly.
- Apply the following SMAs 5,10,20,40,200 to determine which setting contains price the best.
- Once you determine the right SMA, wait for the price to test the SMA successfully and look for price confirmation that the stock is again taking up the direction of the primary trend.
- On the next bar enter the trade.
Fade the Primary Trend using two SMAs
- Find stocks that are breaking down or out strongly.
- Choose two SMAs to apply to the chart (ex. 10 and 20).
- Ensure the price has not been touching the 10 SMA or 20 SMA overly in the last 10 bars.
- Wait for the price to close below or above both moving averages in the opposite direction of the primary trend on the same bar.
- On the next bar enter the trade
We hope this article has cleared most of your doubts about SMA and now you can start using SMA to trade more lucratively.