What is a Simple Moving Average (SMA)?
When creating trend analysis there are a few different technical markers available to choose from. Today the focus is on Simple moving averages. SMA’s are calculated based on price averages from a selected time period. For example if you are creating a chart to examine stock price movements, you may choose to use a 14, 30 and 90 day SMA line. To understand how the simple moving average is calculated, we can use the formula which is :
SMA= (A1+A2+….A(n)) / N
Where “A” is the closing price for each day within the given time frame, so if we use a 14 day sma we will have 14 closing prices for “A”.
“N” will be the number of days for the given time from, so in this case we would be using 14.
In the image above, the yellow and blue dotted lines represent the SMA lines for a chart of UPST.
The time frames picked to create your analysis period will impact the overall picture you get for your analysis. Using a shorter term SMA such as 14 day will give you a more volatile average, but will show a closer image of how the security has moved recently. While a 100 or 200 day SMA gives you a broader view of how the average price has moved for a security without the dip or pump it may be experiencing that week. They are a very customizable technical indicator that can provide insight into price action, making them a valuable tool when trading.
When do you use an SMA or multiple?
When creating your game plan it often comes down to your trading strategy, if and when you will use simple moving averages. Whether you are a long term investor or looking to scalp on options calls, you can tailor the trend lines provided by an SMA to suit your current style. The important part is understanding that it is a tool to add to your analysis but not a concrete pattern that the stock will move exactly up or down along the trend.
Now let’s examine if a shorter-term SMA such as a 14-day is above a longer-term SMA like a 30 or 90 day average, we could see a bullish trend. On the other hand, if the long-term average is above the shorter-term SMA we are using, then we may see a bearish trend occurring.
The “crossing over” can be seen below
Using simple moving averages as part of your trading tools can be beneficial, but as with all tools it has its limitations. It is based on historical price data and unforeseen events can always derail trend analysis. Long term investments tend to be more resistant to fluctuations as investors can wait out any large price swings or average down. While shorter term investments tend to be hit harder when prices become volatile and it is important to set up your charts accordingly to your own investment timeline.
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