Simple Moving Average (SMA)
Indicator Name: Simple Moving Average, or SMA
Indicator Type: Moving Average
Description: There are several different types of moving averages (MAs) in use by forex traders. In fact, moving averages are the most common technical indicator across all financial markets, including the forex.They are called "moving" because each new chart period is included in the calculation, while the oldest period is discarded. This has the effect of the average moving along as time passes and the chart develops.
The simple moving average, as its name suggests, is the simplest form of moving average. It has only two parameters, and they are the "period" and "price". The period determines over how many bars the average is calculated, and the price determines which price in each bar is used - the open, close, high, low, mid-point, or some combination thereof. Closing price is the most common setting for the price parameter, while many different periods are used by different traders in different markets, for different instruments, and at different times.
Calculation: Say we want to calculate an SMA over n periods, where n > 0, and use the closing price. We would add up all the closing prices over the last n periods, and divide them by n. The formula is shown more formally here:
where n is the number of periods, or bars we want to calculate the SMA over, and Pn is the price for period n (in this case, the closing price).
Example: Let's calculate a simple moving average on a daily chart over a period of 5 days, using the following closing prices. P1=100, P2=102, P3=104, P4=107, P5=103. We plug the numbers into our formula and get
Adding up the top and dividing by 5 gives an SMA value of 103.2. This is the value we would plot on our chart for the last day.
Uses: Simple moving averages have too many uses to list them all specifically, but they are generally used as an aid in trend following systems. They are generally more effective when used over long periods rather than short. SMAs are also used extensively as building blocks for many other indicators, such as Bollinger Bands. They can be used to define ranges and can be used as curving trend lines, which can follow price action more closely than straight lines. SMA cross-over systems can be effective at spotting newly formed trends, when a shorter period SMA (or more commonly EMA) crosses over a longer period SMA. There are many variations on this, with each optimized for different markets, different pairs and different timeframes. It should be noted that many such systems are "over-optimized" by traders using back-testing.
Most Common Settings: 100 and 200 period SMA calculated on closing price. The SMA tends to be more effective on longer timeframes.
Strengths: The SMA is easy to calculate and is used by many traders the world over, which can at times make systems based on it self-fulfilling. It tends to react slowly to price changes, particularly for longer periods such as 100 period and 200 period SMAs. This generally produces more reliable signals than other types of moving averages which react more quickly and produce more signals, but are more prone to producing false signals.
Weaknesses: Because of their slow reaction times, simple moving averages have an inherent lag in any signals they produce. This stems from the fact that they use an arithmetic mean, which means that equal weight is given to each day in the period. The reasoning behind this criticism is that more recent price action should be given more weight. In the real world, this can translate into lower average profits per trade for systems that rely on simple moving averages, because trends are already well on their way by the time you get a signal to enter the market. SMA systems are also sometimes criticized because they don't take into account any of the price action that came before the SMA period. If you have a 10-period SMA, then any price action before those 10 periods will not be taken into account.