Last Updated on Sunday, 23 August 2015 05:15 GMT

4.6 Simple Moving Averages (SMA)


A simple moving average (we will simply call this SMA hereon) calculates the arithmetical average of the prices for a chosen period. Values for subsequent days get added, while those of earlier days are omitted. 


Think of it like a camera taking snapshots along the price line, with only a fixed number of price points includible in the photograph. As the photographer moves down the price line he has to include the latest price point in the viewfinder, and drop the oldest price point.


This means that the value of each subsequent moving average will change. I see you frowning, thinking of your school math grades and mentally asking, ‘do I have to do this every day’? Thankfully not, because most charting packages have this feature built in, and you just have to press the button instead of doing the math! 


Now that math is out of the way (phew!) let’s move on to the chart. 


Every moving average that is calculated is plotted on the price chart, along with the price. See, like this: 


Simple moving averages on Forex chart.


Looking at the chart it is immediately clear that the graph of the moving average is far smoother than the price, and has none of the latter’s fluctuations and ‘noise’ from the daily hullabaloo of trading. 


This smoothed graph gives a better picture of areas of support and resistance and a quick and dirty check on the current trend. If the slope of the SMA line is up, and the price is above it, you have an uptrend on your hands. On the other hand, in a downtrend, you’ll find that the SMA line is sloping downwards, with the price line plotting below it.


But this moving average tends to ‘lag’ behind the price, and this lag increases with the number of periods for which the SMA is being calculated. Thus, for example, if the price fell suddenly into a sharp decline, the longer period SMA would take a while to follow the price downwards. See the chart below.


Simple moving average as a lagging indicator.


In this chart you can see how the price has moved down suddenly from A to B, but the shorter-term SMA does not turn down well until point C. The longer-term SMA lagged further behind and dropped only at point D.


There is one other problem. The SMA can sometimes generate a false trending signal due to abnormal variations (spikes!) in the price. A routine calculation of the SMA would simply take all the periods as equally important, and work out the SMA figure. If one of those figures was a freaky spike, the SMA wouldn’t know, and just turn up or down.  Obviously, in such a case, it would be incorrect to assume that the trend had changed when in reality the villain of the piece would be that one ‘spiky’ day!


Don’t worry; we have a trick up our sleeves to sort these problems out. See the next chapter on Exponential Moving Averages and all will be sunshine again!


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