The simple moving average is basically the simplest way to calculate a moving average. This is an arithmetic mean in which the sum of the last N prices (P) will be taken and divided by N, where N is the period. In other words is an average where all data prices have the same weight. Remember that the most usual is to calculate this indicator using closing prices and therefore from now on we will refer to the closing prices.
It is one of the most used technical indicators by traders in all markets. Many trading systems use simple moving averages, mainly as a trend indicator.
The simple moving average is usually represented by the acronym SMA.
The moving characteristic implies that the average moves following the quotes, that is, it collects the data that is generated in the last session, and in turn, discards the oldest data of the time series. Within all the existing indicators in the world of technical analysis, it could be said that well-used moving averages are an excellent indicator of market trends.
The moving average is a trend indicator that never anticipates the movement or trend of the markets, that is, it simply follows the price curve confirming the current trend. It does not anticipate changes of tendency, but it can confirm them.
Example of a simple moving average (SMA)
Suppose we calculate a SMA of 5 periods applied to the closing price on a 1 hour chart. Each value indicated by this moving average is calculated by taking the closing prices of the last 5 hours, which are added and divided by 5.
Today almost all trading platforms, including the most simple, simple moving averages include among its technical indicators. Thanks to this, the trader does not have to calculate the SMA manually.
In the price chart, the SMA are plotted as lines following the price, although it should be noted that are delayed with respect to the price action.
In the picture below we can see how simple moving averages draw a smooth line of the price. In this case you may also notice the delay in the indicator reactions when the price rises or falls, a common disadvantage of this type of indicators. The SMA allow an overview of the market trend, which can be supplemented by drawing several moving averages of different periods on the same price chart In fact, crossings of moving averages of different periods are used in many trading systems as entry signals, although the use of filters is recommended because false signals are common.
Considerations on simple moving averages
- The longer the period of the SMA, the greater the smoothing and slower the reaction to the price movement. This slower reaction is easily identifiable. For example, in the previous price chart we can see how moving averages with larger periods moves away further from the price compared with the moving averages with shorter periods.
- Moving averages may indicate the momentum and market sentiment when comparing two MA with different period:
- Faster moving averages (shorter period) over slower moving averages (longer period) indicate a bullish market sentiment.
- Faster moving averages (shorter period) lower slower moving averages (longer period) indicate a bearish market sentiment.
One drawback of the simple moving average is that it changes twice with each data. First, when a new price is added to the moving average, which is very good, because what interests us is that the moving average reflects the changes in the price. But later, something less desirable happens, and that is that the simple moving average changes again when an old price comes out of the indicator, at the end of the time period covered by the average. This is not desirable because it can give us a false signal in case the value that comes out is very large or very small.