What is Simple Moving Average (SMA)?

The SMA is a fundamental tool in technical analysis that helps traders and investors understand and interpret market trends. It is a simple but effective tool that smooths price data in order to help identify the direction and strength of an underlying trend. In this article, we are going to discuss what SMA is as well as how it operates and where you can apply the traders.

Understanding Simple Moving Average

A Simple-Moving-Average (SMA) is an average of a specific number of calculated price points in the past. For example, a 10-day SMA is the summation of closing prices in the last ten days divided by 10. This calculation solves daily short-term price movements and gives a clear vision of the overall market direction.

Calculation of SMA

For example, a 5-day SMA is calculated by summing the closing prices of last 5 days and then divided it to generate average value. For instance, if closing prices for five days are $10, $11, $12, 11, and $14 then the value of a 5-day SMA will be:

SMA =(10+11+12+11+14)5 = 11.6

The SMA can be used by you on longer or shorter time frames, and almost every kind of strategy could benefit from some form it.

Applications of SMA

Identifying Trends

A crucial role of SMA is to discover trends on the market. If the SMA is increasing, you have a bullish trend, if it is decreasing you are dealing with a bearish one. The 200-day SMA is more of a long-term trend-following indicator and the 50-day SMA would be used for an intermediate term.

Trading Signals

SMAs are often used to determine possible trading signals. When price crosses over its sell range of SMA; a buy signal will be triggered on the converse when it crosses below. Also, SMA crosses - where a short term SMA cuts long-term SMA - can signal bullish or bearish. 

One such popular indicator is the golden cross, which occurs when a 50-day simple-moving-average (SMA) crosses above its 200-day SMA - some traders interpret that as bullish market. A "death cross," on the other hand, denotes a bear market and happens when the 50-day SMA drops below the 200-day SMA.

Support and Resistance Levels

Dynamic support and resistance levels can also be provided by SMAs. A moving reference point, the SMA line can assist a trader in choosing strategic points for stop loss and take profit. In an upward trend, the SMA can be a support which is being pushed up further by the stronger buying volume.

Strengths and Weaknesses of SMA

Strengths

• Simplicity: The SMA is transparent with its formula making it user friendly for traders at all stages.
• Trend Identification: It helps identify a trend's direction and strength.
• Smoothing Effect: By averaging price data, the SMA filters out short term noise and helps us to identify trends.
• Widely Used: Because SMAs are used by a lot of traders, they can become self-fulfilling prophecies in the market.

Weaknesses

• Lagging Indicator: This means that the value of an SMA is calculated based on past prices; thereby, giving you signals after it has been too late.
• Whipsaw Effect: SMAs are not successful in choppy or ranging markets, as they can lead to false signals and the whipsaw effect which results potential losses.
• No Volume Consideration: SMAs only take price into consideration and do not account for trading volume, which can be some times useful to know the strength of a trend.

Combining SMA with Other Indicators

Traders often use SMAs in conjunction with other technical indicators to partially address those weaknesses. Some of the most popular form using SMAs are grouped with other indicators such as RSI, MACD, or Stochastic Oscillator. These indicators give extra weight to signals formed by the SMA and hence, strengthen your knowledge about market state more tangibly.

Conclusion

The Simple-Moving-Average (SMA) is one of the core indicators in a trader or investor's toolbox. Its simple, and effective for trend identification and trading signal generation is un-measurable. However, like any indicator, it has its limitations and should be used in conjunction with other tools for the best results. Knowing how to compute and implement SMAs helps traders upgrade their market study, influence better decision-making.

For the newbie who wants to get a taste of technical analysis, or for when you are struggling in your trading journey and want some back-to-basics schooling; learning this simple-moving-average is an excellent first step. Whether you are new to trading or relatively experienced, with practice and the best setting of indicators, SMAs can enhance your ability to yield better results on your trade.