What is SMA? Practical application of Simple Moving Average in trading

Understanding Simple Moving Average (SMA) Indicator

The Simple Moving Average (SMA) is an important tool in technical analysis, relied upon by many traders to determine the direction of an asset’s price movement. For beginners just starting out, what is SMA? This is a fundamental question—essentially, it is calculated by averaging the prices over a specific period, helping traders filter out market noise and see clearer price trends.

How SMA is Calculated

The calculation of the simple moving average is straightforward: add up the closing prices of an asset over a specified period and divide by that number of periods.

For example, a 20-day SMA, assuming the closing prices for the past 20 trading days are:

Week 1 (5 days): 100, 105, 108, 99, 101
Week 2 (5 days): 98, 103, 105, 104, 102
Week 3 (5 days): 103, 99, 101, 106, 104
Week 4 (5 days): 105, 108, 110, 109, 107

Calculating the first data point: (100+105+108+99+101+98+103+105+104+102+103+99+101+106+104+105+108+110+109+107) ÷ 20 = 104.15

To compute the next data point, you remove the first day’s data (100), add the new price for day 21, and recalculate the average. This rolling calculation forms a continuous trend line.

The calculation principle for 50-day or 200-day SMAs is the same, just over longer periods with more data points, resulting in a smoother trend line.

What is SMA and Its Core Function

The biggest advantage of the simple moving average is smoothing out price fluctuations, allowing traders to clearly identify the long-term trend of an asset. When the SMA curve is rising, it indicates an upward trend; when it is falling, it suggests a downward trend.

Depending on the timeframe, the application of moving averages varies:

• 200-day SMA: Usually represents a long-term trend, suitable for judging the overall market direction
• 50-day SMA: Commonly used to identify medium-term trends, helping swing traders grasp the rhythm
• 10-day or 20-day SMA: Used to capture short-term price fluctuations

It is important to note that SMA has a lagging nature. Since it is based on past price data, it can only reflect past price movements and cannot predict future trends. When trading signals appear, the market may have already moved significantly. Additionally, in choppy markets, prices often cross the moving average frequently, generating many false buy or sell signals, which can mislead trading decisions.

Trading Strategies Based on SMA

Method 1: Trading based on the relative position of price and the moving average

When an asset’s candlestick crosses above the simple moving average, it is generally seen as a bullish signal, and traders may consider opening long positions. Conversely, when the candlestick crosses below the moving average, it is usually interpreted as a bearish signal, and traders might reduce positions or open short positions.

Method 2: Using crossovers of multiple moving averages

Traders often plot two SMAs of different periods to determine entry and exit points. For example, when the 20-day SMA crosses above the 50-day SMA, it is called a “Golden Cross,” indicating a potential upward trend and a strong buy signal. Conversely, when the 20-day SMA crosses below the 50-day SMA, it is called a “Death Cross,” suggesting a possible downward trend.

This multi-moving average strategy effectively filters out short-term noise and enhances the reliability of trading signals.

How to Set Up SMA on Trading Platforms

Most charting software has similar steps for setting technical indicators. The general process is:

1. Find the “Indicators” or “Indicator Library” option in your charting software
2. Search for and select the “Moving Average” indicator
3. Enter the desired period (e.g., 20, 50, 200) in the parameter settings
4. Adjust line colors and styles as needed to distinguish different periods’ SMAs
5. To add multiple SMAs, repeat the above steps, assigning different colors for each period

Conclusion

While the simple moving average is a commonly used technical analysis tool, relying on it alone can generate false signals. To improve trading success, traders should combine SMA with other technical indicators (such as RSI, MACD, Bollinger Bands, etc.) to develop a more comprehensive and reliable trading system. Remember, there is no perfect indicator—only effective combinations.