Simple moving averages (SMA) are the most basic type of moving average.
It is called ‘simple’ for a few simple reasons.
It’s simple to calculate it. It’s simple to use. And most importantly, its simplicity is simply useful for Forex traders.
Don’t worry, we’ll make it simple.
SMA is calculated by taking a series of prices (or reporting periods), adding these together and then dividing the total by the number of data points.
For example, if you were to calculate the SMA for a ten-day period, you would take the values of the last ten days and divide the result by ten.
Now, let’s say that the last ten data points of an asset were: 80, 81, 81, 82, 80, 82, 89, 82, 82 and 83. The moving average would add these figures together and divide by ten, resulting in an average of 82.2.
Then each time a new price becomes available, the average “moves” so that the average is always based only on the last same number of variables. In this case, if the next number in the sequence was 86, the oldest rate (80) would be dropped and the new average would equal 82.8.
In another example, if you plotted a 5 period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours, and then divide that number by 5.
Or if you were to plot 5 simple moving averages on a 30-minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.
Or if you were to plot the… Okay, okay, just kidding. I know you get it!
And to be completely honest with you, most charting packages will do all the calculations for you anyway.
But in our defense, there’s a good reason we bored you with all the maths on how to calculate simple moving averages.
Understanding how an indicator works means you can adjust, tweak it and eventually create different strategies as the market environment changes.
Soooo we take the sorry back, sorry.
Now, let’s take a look at how simple moving averages smooth out the price action.
On the daily chart below, we will plot three different SMA’s, a 10-period (short-term), a 20-period (medium-term) and a 50-period (long-term) simple moving averages.
Let’s start off with a 10-period MA overlaid on top.
Notice how the 10-period moving average seems to follow the price, but the line is smoother and lags somewhat.
Now take a look at the 20-period MA. It is even smoother and lags even further behind the price. This isn’t particularly surprising when you consider it’s taking into account the last 20 periods rather than the last ten.
For this reason, technical analysts would say that the 20-period MA is slower than the 10-period MA.
And lastly, take a look at the 50-period MA. You can clearly see that it’s even smoother, with even more lag.
Of the three moving averages, the 50 MA is the slowest while the 10 MA is the fastest.
You can also see, the longer the SMA period is, the more it lags behind the price.
At the same time, the longer period you use for the SMA, the slower it takes to react to the price movement.
Instead of just looking at the current price of the market, the MA’s allow traders to see a broader view, and provide a better understanding of the general direction of its future price.
But just like everything else, Simple Moving Averages aren’t perfect.
The problem with the simple moving averages is that they are susceptible to spikes.
And when this happens, this can give us false signals.
And nobody likes false signals…
In the next lesson, we will show you what we mean by that, and introduce you to another type of moving average to avoid this problem.
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