What is a Simple Moving Average Trading Strategy?

The market price of a security is the value of the security placed by the buyers and sellers in the market. Historical data relating to the market price of an asset proves to be an indicator for future price trends. Price movements are thoroughly studied by investment analysts to identify opportunities. Simple Moving Average is a widely used technical analysis tool to predict future price trends by analyzing historical price data. It can be applied to all financial securities such as shares, commodities, currencies, indices, and exchange-traded funds.

Simple Moving Average (SMA): Trading Strategy

A simple Moving Average is the average market price of a security over a specified period. It is referred to as the ‘moving’ average since it is plotted on a chart bar by bar and forms a line that moves along the chart as the average price changes.

Calculation of Simple Moving Average

The simple moving average is calculated by adding the price of a security over a period and then dividing that figure by the number of periods.

For example, adding the closing prices of a security for the previous month and then dividing the total by the number of days in the month.

The formula for a simple moving average is:

SMA = (A₁ + A₂ + A₃ + … + A_N)

                         N

AN = the price of the asset at period N

N = the number of total periods

Case Study: Simple Moving Average

For example, the closing price of HDFC Bank Ltd over 10 days is as below:
Week One (5 trading days): 1200, 1210, 1240, 1235, 1220
Week Two (5 trading days): 1220, 1200, 1205, 1205, 1200

A 5-day moving average would average out the closing price for the first 5 days as the first data point. The next data point would drop the earliest price, add the closing price on Day 6, then take the average, and so forth. Similarly, a 90-day moving average would gather enough data to calculate the average of 90 consecutive days on a rolling basis.

The 5-day simple moving average for HDFC Bank Ltd = (1200+ 1210+ 1240+ 1235+ 1220)/5 = Rs. 1221.

For decision-making, the 5-day moving average is to be compared with the current market price. On Day 6, the closing price of HDFC Bank is Rs. 1220 which is lower than the 5-day simple moving average.

Characteristics of Simple Moving Average

The simple moving average has the following features:

• Customizable: Simple moving average may be customized for different periods. A short-term investor may use a 10-day simple moving average to analyze short-term trends. On the contrary, a long-term investor may use a 200-day simple moving average. Typically, short-term simple moving averages respond faster to price fluctuations of the underlying security in comparison to long-term moving averages.
• Volatility: A simple moving average also smooths out volatility. The longer the time horizon for the moving average, the smoother the simple moving average. The short-term moving average tends to be more volatile but the average is closer to the data source.
• Lagging Indicator: A simple moving average is a lagging indicator since it is based on past price movements. The lag is directly proportional to the period of SMA. The longer the time of SMA, the higher the lag.

Application of Simple Moving Average

At a very basic level, traders and analysts employ technical tools such as simple moving averages to analyze market sentiment. Simple Moving Average is primarily applied for trend analysis and for identifying support and resistance levels.

Trend Analysis:

The simple moving average is employed to ascertain whether the price of a security is trending upwards or downwards. The thumb rule for trading with a simple moving average is that a security trading above its simple moving average is in an uptrend whereas a security trading below its simple moving average is in a downtrend. For example, a security trading above its 20-day simple moving average is said to be in a short-term uptrend. Similarly, a security trading below its 200-day simple moving average is in a long-term downtrend.

Another analytical use is to compare a pair of simple moving averages, each covering different time frames. If a shorter-term moving average is above the longer-term moving average, then it signals an expected uptrend. In contrast, if a longer-term moving average is above the shorter-term moving average, then it signals an expected downtrend.

Support & Resistance:

During a trend, a simple moving average may help to identify levels of support and resistance. For example, security in a long-term uptrend may fall marginally but find support at the 200-day simple moving average. Thus, the 200-day simple moving average serves as a support level and can help identify a change in trend.

Limitations of Simple Moving Average

A simple moving average relies on historic data to predict future trends. However, it is commonly believed that the market price is efficient and reflects all available information. In an efficient market, historical price data will not have any impact on the future direction of the asset price. Thus, the appropriateness of a simple moving average is challenged.

Furthermore, it is unclear whether the emphasis should be placed on the most recent data in the period or on more historical data. A simple moving average assigns equal weightage to each day of the period. Some traders believe that recent data will accurately depict the current trend of the security but others opine that favoring certain dates over others will bias the trend.

How Are Simple Moving Averages (SMAs) Used in Technical Analysis?

A simple moving averages trading strategy is employed by traders to chart the price movement of a security and ignore the day-to-day price fluctuations. Traders can compare short, medium, and long-term trends over large periods.

A 200-bar simple moving average is usually used as a substitute for the long-term trend. Likewise, a 50-bar simple moving average is used to evaluate the intermediate trend. Short period simple moving averages are used to determine short-term trends.

Various trading patterns use simple moving averages including the following:

• Death Cross: A death cross occurs when the 50-day simple moving average falls below the 200-day simple moving average. A death cross is considered to be a bearish signal and indicates that the price is expected to fall further.
• Golden Cross: A golden cross occurs when the 50-day simple moving average rises above the 200-day simple moving average. A golden cross is viewed as a bullish signal and presents an opportunity to buy.

A simple moving average trading strategy can be used not only in technical but also for fundamental analysis. While the methodology of analysis is different, a simple moving average is used to complement both. A simple moving average is an important tool and it is best used along with other indicators such as volume analysis and trendlines.

SMA Crossover

The price of security crossing its simple moving averages is often used as a trigger trading signal. The most popular crossovers include bullish, bearish, and moving-average crossovers.

Bullish Crossover: A bullish crossover occurs when the price of a security moves above its simple moving average after being below it. The price movement indicates that the correction is over and a possible uptrend is starting. Thus, the bullish crossover is an indicator to enter a long trade. Bullish crossover is quite reliable in a trending market although it may fail in a rough or sideways market. Bullish crossovers are less important in case of a long-term downtrend.

Bearish Crossover: Bearish crossover is the exact opposite of a bullish crossover. It occurs when the price of a security falls below the simple moving average after trading above it. Bearish crossover signals that the uptrend is over and a downtrend is expected. Bearish crossover is a signal to exit a long trade or enter a short position. A bearish crossover may not be efficient in a rough or sideways market.

Moving-Average Crossover: Moving average crossover occurs when a short-term simple moving average cross over a long-term simple moving average. Golden cross and death cross are examples of moving-average crossovers.