Simple Moving Average

The Simple Moving Average is arguably the most popular technical analysis tool used by traders. The Simple Moving Average (SMA) is often used to identify trend direction, but can be used to generate potential buy and sell signals. The SMA is an average, or in statistical speak - the mean. An example of a Simple Moving Average is presented below:

• The prices for the last 5 days were 25, 28, 26, 24, 25. The average would be (25+28+26+26+27)/5 = 26.4. Therefore, the SMA line below the last days price of 27 would be 26.4. In this case, since prices are generally moving higher, the SMA line of 26.4 could be acting as support (see: Support & Resistance).

The chart below of the Dow Jones Industrial Average exchange traded fund (DIA) shows a 20-day Simple Moving Average acting as support for prices.

Moving Average Acting as Support - Potential Buy Signal

When price is in an uptrend and subsequently, the moving average is in an uptrend, and the moving average has been tested by price and price has bounced off the moving average a few times (i.e. the moving average is serving as a support line), then a trader might buy on the next pullbacks back to the Simple Moving Average.

A Simple Moving Average can serve as a line of resistance as the chart of the DIA shows:

Moving Average Acting as Resistance - Potential Sell Signal

At times when price is in a downtrend and the moving average is in a downtrend as well, and price tests the SMA above and is rejected a few consecutive times (i.e. the moving average is serving as a resistance line), then a trader might sell on the next rally up to the Simple Moving Average.

The examples above have been only using one Simple Moving Average; however, traders often use two or even three Simple Moving Averages. The potential advantages to using more than one Simple Moving Average is discussed on the next page.

(Source: onlinetradingconcepts.com)